Sunday, May 28, 2017

Quarterly CAPE review

As many readers may know I am a big advocate of the CAPE ratio in identifying overvalued and undervalued countries. If you don't understand what the CAPE ratio is or how to use it you can read an article I wrote about it here.

I use a couple of websites that track the CAPE ratio. They are here and here.

Here are the current cheapest markets:

Here are the current most expensive markets:

So the idea is to sell the expensive markets and to buy the cheapest markets. On a long term basis (10 years) this has proved to be a winning formula. Meb Faber wrote a paper about this and show through backtesting that this does in fact work.

The key sentence in the paper, in my opinion, is the following:

What we find is no surprise, it very much matters what price one pays for an investment! Indeed
it is an almost perfect stair step - future returns are lower when valuations are high, and future
returns are higher when valuations are low.

This meshes with a statement from Howard Marks that I have in my investment quotes page:

Superior results don’t come from buying high quality assets, but from buying assets – regardless of quality – for less than they’re worth. It’s essential to understand the difference between buying good things and buying things well

Looking at the CAPE ratios it becomes apparent that the US market is overvalued. That does not mean it is in imminent danger of crashing. In fact it will probably go a lot higher as sentiment is still fairly negative towards the market by the average person.

What the ratio tells us is that over a long period the returns on US stocks will probably be lower because they are already at a historically high valuation. Conversely the countries on the undervalued list will more than likely have higher returns over the next ten years because they are undervalued historically.

Most people do not have a long time frame and will not act on this information. But we also know that most people cannot match must less beat the S&P 500. In fact most investors either lose money or earn paltry returns.

I use this as a tool and have been selling off US stocks. I have been buying Russia and Eastern Europe. I will not be looking to buy some of the larger Chinese stocks.

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