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Robert Abbott
Robert Abbott
Articles (739)  | Author's Website |

Global Value: Valuation Extremes and Buy-Sell Signals

Using CAPE ratios with countries is as effective as using CAPE ratios for stocks

February 24, 2020

To begin chapter eight of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” author Mebane Faber asked if extreme valuations are signals of bubbles (on the high side) or generational buying opportunities (on the low side).

To look for an answer, he turned back to the database of global CAPE (cyclically adjusted price-earnings) ratios and returns first described in chapter seven. There, he looked at all cases in which the CAPE ratio was below 7 at the end of every year between 1980 and 2013. That turned out to be quite infrequent and occurred in only 4% of cases.

Many of those extremely low valuations were found in countries that had gone through financial turmoil. For example, the geopolitical storms in the so-called PIIGS countries: Portugal, Italy, Ireland, Greece and Spain. They were the weakest European Union economies during the European debt crisis.

Faber obviously wanted to know what would have happened had a brave investor put their money into stocks in such countries. The returns were exceptional:

  • The compound annual growth rate over one year was 30.9%.
  • Over three years, the CAGR was 17.6%.
  • Over five years, it was 20.5%.
  • Over 10 years, it was 14.4%.

Some impressive returns, but what would have happened to investors who invested in markets that were trading in the top 4% of valuations instead? Faber looked at years ending with CAPE ratios of 45 or higher and again found notable results. This time, though, the results were notable by how bad they were:

  • The CAGR over one year was -8.9%.
  • Over three years, it was -4.1%.
  • Over five years, it was -0.8%.
  • Over 10 years, it was 1.2%.

As Faber wrote, “Investing in extremely expensive markets is a recipe for disaster.” Despite that, investors often jump into hot markets, hoping to share in some of the profits being produced (at least temporarily).

On the other hand, investors are often reluctant to jump back into markets when they have sold off dramatically despite these being the moments that promise the very best returns. He cited Mark Yusko, the CEO of Morgan Creek Capital Management: “Investing is the only business I know that when things go on sale, people run out of the store.”

For context, the author referenced the 1989 bubble in Japan, one that reached a CAPE ratio of 100 (compared with the dotcom bubble of 1999 that peaked at 45). He noted some experts attributed the two lost decades in Japanese markets after 1989 to demographic, cultural and geopolitical forces. He, though, argued that a bigger reason for those lost decades was simply the size of the bubble. At a CAPE of 100, this was the biggest bubble ever seen in a stock market, and so it should be no surprise it took 21 years to return to a normal valuation.

In the United States, it took about nine years for the market to normalize after its all-time high in 1999. Which prompted the question: How long does it take for markets to recover from bubbles? The author found from his data that the median recovery time from a bubble ratio of 45 was three and a half years. That was based on a sample of 17 bubbles of at least 45 and excluded the extraordinary Japanese bubble of 1989.

That left him pondering the feasibility of turning such findings into a system for portfolio management or trading.

In chapter nine, he began working toward a “global stock trading” system. He wrote that many valuation measures also offer estimates of future returns. For example, Dimson, Marsh and Staunton’s “2011 Global Investment Returns Yearbook” found a spread of 8% per year across 19 countries when they sorted by dividend yields.

Would the same hold if countries were sorted by CAPE ratios? Yes. Using his database, Faber concluded that the spread between the expensive countries and the cheap countries was about the same as the dividend spread. Returns from the lowest-valuation countries outstripped returns from the highest-valued countries.

But that premise doesn’t hold if all countries are overvalued, as they were in 1999. Faber did further research and determined that investors should only invest in a country with a CAPE level of 18 or less. If nothing was available at or below that level, then it is best to stay in cash. Adding an absolute CAPE ratio filter, such as 18 or less, also led to reduced volatility and smaller drawdowns.

He also observed that the system may be simple, but it certainly wouldn’t be easy. Only a few among us leaped into Greek, Italian or Russian stocks in the wake of the 2008 financial crisis.

According to Faber, we also can discover opportunities by observing the maximum drawdown or how much a market has already declined. At the end of 2013, these were the results:

  • If a drawdown reduced the CAPE ratio by less than 10 (for example, from 45 to 35), an investment made at that point would have returned -41%.
  • If it resulted in a 10 to 15 drop in the CAPE ratio, then an investment would have returned -31%.
  • If the CAPE ratio declined by more than 15, then an investment would have returned -14%.

Those returns are all negative, but again we see the same pattern: The lower the CAPE ratio, the better the return or, in this case, the less damage to a portfolio. In the author’s view, buying stocks in low-ratio countries is the same as buying countries that have already experienced the greatest CAPE ratio declines.

Of course, buying into a low ratio country is not enough by itself. Investors also must be patient and wait for a return to something like fair valuation. And how long would that take? Faber went to his database once again, looking at CAPE ratio measurement horizons of one to 10 years. He concluded that the best range was the one that Benjamin Graham liked, five to 10 years.

Finally, the author emphasized the need for diversification, of buying a basket of low CAPE ratio countries, not just a couple of them. Investing in a single country is about the same as investing in a single stock. As to a specific number, Faber thought that a basket of the 10 cheapest countries would work and noted that would roughly equal 25% of developed and emerging countries.

Conclusion

In chapters eight and nine of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” Faber added new components to his system for investing in global value stocks.

He began chapter eight by asking if extreme valuations would act as signals for buying and selling. The answer is yes, extremely low valuations signal buying opportunities and extremely high valuations signal that it’s a good time to sell.

In chapter nine, he looked at this issue from a portfolio perspective. By sorting countries by their dividend yields or CAPE ratios, investors can establish the foundation of a value portfolio in equities. A basket of equities from about 10 low-valuation countries held for five to 10 years would appear to be the best bet.

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.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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