Saturday, February 27, 2016

How to Get Rich Lesson Three: What is CAPE and how to use it for market beating investment returns

One of the secrets to investment success is the price paid for a stock. Buying at the top of a market when valuations are stretched will typically lead to lower returns. Conversely buying at the bottom can lead to market beating returns. Sounds easy but most people cannot do it. They cannot do it because they either will not or cannot remove their emotions from their investment decisions.

It is very difficult to go against the crowd and be a buyer of downtrodden countries or stocks when everyone else is selling or advocates selling. It makes sense because our chimpanzee brain is telling us "danger stay away you could get hurt". This is part of our primal survival instinct. Our brain is saying stay with the herd and your chances of survival are higher than going it alone. However we are in search of market beating returns not surviving a sabertooth tiger attack.

What if there was a tool that would help an investor to decide if a market was cheap or expensive. What if the tool has been been back tested and proven to be effective in determining if a market is cheap or expensive. What if using this tool leads to market beating returns. Would you use it?

CAPE or Cyclically Adjusted Price to Earnings is a valuation measure used for determining the relative valuation of various stock markets. It was created and published by Nobel Laureate Robert Shiller. Basically the higher the number on the scale the lower the expected future return. Here is a chart with the CAPE ratio for the US going back to 1881:

Below is chart that shows the 10 year return on US stocks versus the CAPE:

I got this information from a recent book by Med Faber entitled "Global Value" which I encourage you to read and which he gives away for free on his site. I actually encourage folks to read all of Mr. Faber's books as I have found him to be one of best finance/investment writers I have read.

What this chart shows is that the higher the CAPE ratio that a market is trading at the lower the expected returns will be over the next 10 years. This of course makes perfect sense as the higher the CAPE ratio the more expensive the market tends to be.

The way to use this tool then is to calculate the CAPE ratio for various markets around the world which will then give an investor an idea which markets are over valued or undervalued. The investor could then do something as simple as buying an ETF for the undervalued countries and holding until the country becomes fairly valued again. Luckily there are few sites that do that already here and here.

This is where trusting in the math and research comes in and where most investors fail. As of the writing of this blog (2/27/16) the cheapest countries as represented by CAPE ratio are Russia and Brazil.

Most People will not buy these two countries because of the recent bad news and negative current perception of both countries and the bias it creates. However we are talking anticipated 10 year returns not what will happen in the next week, month, or year. I own the Russian ETF as I believe that the Russian economy is predominately tied to the price of oil which I think will be going higher over the next few years

I believe oil will heading higher because the recent low oil prices are causing a major pullback in capital spending on new oil wells. As oil production is depleting it requires a certain amount of continuing investment to maintain not too mention to increase production. Sufficient investment is not happening to replace reserves at these low prices. As oil demand is pretty much inelastic and is required for civilization to run at some point supply and demand will intersect and oil prices will move higher.

The trick is timing as we do not know when this will happen. However we do know form what the CAPE ratio says that Russia is way cheap and has one of the highest correlations to the oil price of any country. So it is good bet that as oil prices rise over the next 3-5 years that Russia will rise also.

As the oil price has declined so have Russian stocks
The CAPE ratio is not a 100% set and forget tool and it is not a market timing tool. Nothing is guaranteed in investing and speculating. However it has demonstrated itself as a fairly accurate tool that can be used as a starting point in identifying historically cheap markets which can then be researched further for opportunities.

If you want to get rich you cannot just haphazardly throw darts at the stock page. You must have a plan and demonstrably useful tools to limit risk while also enhancing your returns. The CAPE ratio is one of the tools I use to help me get rich.

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