Is the CAPE (cyclically adjusted price-earnings) ratio a reliable indicator for stock and index valuation?
That’s the question with which author Mebane Faber wound up chapter five of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.”
The author argued that it was reliable if we use it for long-term analysis rather than short-term, and understand it is something of a “blunt” instrument.
But, how does it compare with other valuation methods? According to Faber, it aligns with “nearly every value measure we track.”
At the time his book was published in March 2014, it showed that American stocks were quite expensive. At the close of trading on Feb. 21, 2020, the CAPE ratio stood at 32.3, which is 90% higher than the historical mean of 17 - also quite expensive.
Those “other valuation methods” mentioned above are the subject of chapter six of the book. The author looked at information provided by Dr. John Hussman (Trades, Portfolio), who listed these metrics:
- Price / normalized forward operating earnings
- Price / 10-year earnings adjusted for profit margins
- Price / 10-year inflation-adjusted earnings (Shiller P/E or CAPE)
- Market capitalization of non-financial equities / nominal GDP
- Tobin’s Q
- Price / Revenue
Hussman found that all six of these metrics delivered similar valuations and all caught the ups and downs of the market over years and decades. In all instances, including the CAPE, there are overvaluation signals. Some were quite extreme, such as during the dotcom boom of the late 1990s, but the key is that until the overvaluation recedes, no matter how long that takes, we need to expect muted returns. Faber puts those muted returns at 2% to 4% per year in nominal terms, and perhaps 0% to 2% after inflation.
Faber went on to report that one of the most important factors underlying earnings is profit margins. He also wrote that it appears that profit margins can experience reversion to the mean. That indicates investors should be conservative when estimating future returns; margins can fluctuate significantly, and it should never be assumed they will stay at elevated levels or will increase.
For more on mean reversion, he turned to Andrew Lapthorne of Societe Generale. Lapthorne argued that mean-reversion in earning is “as undeniable as the economic cycle itself,” even though it may take a long time in arriving. He added that price-earnings calculations, cyclically or trend adjusted, will always produce a conservative estimate of valuation. That’s important, because a conservative valuation offers a margin of error, and when peak earnings revert to the mean, valuations will collapse as well.
In the months before this book was published, in March 2014, Faber wrote that the American market was overvalued and even dangerous. Therefore, it made sense to look beyond the United States, to search for countries with less or no overvaluation. He added, “While the U.S. CAPE ratio signals caution, similar CAPE ratios for country stock markets around the world signal opportunity. Using the CAPE ratio to identify the most attractive countries and regions around the world can lead to impressive results.”
In chapter seven, the author picked up that theme of global investing. Faber created a database of 44 countries. Given variations in how long their records went back, he included only data from 1969 forward.
Between 1969 and 2013, he found that CAPE ratios globally were mostly in the same range as American ratios, from 7 to 45 (while the U.S. range was 5 to 45).
There were a couple of prominent exceptions, including Japan, which had a CAPE ratio of 100 in 1989. Overall, though, the CAPEs outside the U.S. averaged from 15 to 20, and at the end of 2013, the “foreign developed” countries ratio stood at 16, while the “foreign emerging” sat at 15.
Faber also reviewed all countries, year by year, since 1980, to observe the CAPE ratio levels and future returns. In 1980, that involved 10 countries, which increased to 20 countries in 1990, 30 by 2000 and 44 in 2010.
The results generally confirmed what was going on in the United States, and the lesson was clear: “Buy low, sell high.”
Conclusion
Whether you’re buying or selling in America or in any other country, it’s always important to buy at a low or discounted price. Not surprisingly, that aligns with the lessons of value investing, where investors seek a margin of safety between a stock’s intrinsic value and its market price.
In chapter six, Faber showed there is nothing unique in the CAPE ratio showing overvaluations. They also show up with other valuation metrics as well, and there is also the important point that profit margins and earnings are, like stock prices, subject to reversion of the mean.
In chapter seven, the author demonstrated that the overvaluations uncovered by the CAPE ratio are not exclusive to the United States; they occur in foreign markets as well. So, investors should monitor the valuations of stock markets in other countries because they may have bargains not available in America.
Disclaimer: This review is based on the book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market” by Mebane (Meb) Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Global Value: The CAPE Ratio, Inflation and Criticisms
- Global Value: The CAPE Ratio
- Global Value: Bubbles and Emotions
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