One of Nobel laureate and Yale University economist Professor Robert Shiller's most famous metrics is the cyclically-adjusted price-earnings ratio, or CAPE. CAPE eliminates the distortions caused by big swings in profits that can make normal price-earnings ratios at any moment look artificially inflated or depressed. CAPE smooths those peaks and valleys by averaging the S&P 500's index profits over the trailing 10 years; it then adjusts those earnings for inflation. The numerator (the "P" or price) is simply the current reading for the S&P 500 index. The denominator (the "E") is that inflation-adjusted figure for earnings per share.
Currently, the CAPE is flashing red, and it is at its second highest level ever at over 37. Only during the internet bubble in 2000 was it higher at over 43. We all know what happened after that.
The Excess Cape Yield
The issue with the CAPE is that it does not consider risk-free interest. The 10-year treasury bill rate is widely considered as the risk-free interest rate. As risk-free interest rates fall, the market can support higher price-earnings ratios and CAPE. The Covid-19 crisis has caused central banks to lower interest rates to an unprecedented degree, which has caused a boom in stock prices in the U.S. as well as in many other countries.
Last year, Professor Shiller published an article introducing the “Excess CAPE Yield,” or ECY, which is the inverse of the CAPE (earnings over price) minus the 10-year bond yield. Professor Shiller wrote:
"Market observers have noted the potential role of low interest rates in pushing up CAPE ratios. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest-rate cuts by central banks may be used to justify higher equity prices and CAPE ratios.
Thus, the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate. This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive."
Guru Focus added this new valuation metric, the Excess CAPE yield (ECY), to the site in April 2021. This is a welcome addition to our valuation toolset and I encourage readers to regularly visit the page to get a sense of market valuation. At present, the ECY in the U.S. is at 2.8%, which is above the 10-year treasury yield of 1.5%. Therefore, equities still appear better investments than 10-year treasury bonds. The present ECY compared to the last 20 years does not look too bad (as compared to the CAPE).
GuruFocus describes this chart as follows:
The graph above compares the ECY and actual 10-year annualized excess return of the stock market. It can be seen that the fluctuation of ECY is similar to the actual annualized excess return, which suggests ECY can be helpful in forecasting stock market returns in the long-term.
The current data suggests that investors in the U.S. should be prepared for low returns (less than 3% after inflation) over the next 10 years. Yes, it is better than losing money, but it won't buy you a Tesla (TSLA) Roadster.
So, what about valuations outside the US?
I gathered data to get an idea of valuations for larger markets outside the U.S. The data from various sources is presented below. The Shiller Earnings Yield in column 3 is the reciprocal of the CAPE in column 2. I was not able to compute an ECM for markets outside the U.S. due to inability to source reliable core inflation data. Therefore, the best measure is to ignore Inflation and just focus on Shiller yield minus 10-year bond yield (given in column 5 below). This column 5 gives us theequity premium over 10-year bonds, but without inflation adjustments. ECM would add core inflation to the equity premium score, but since we are looking at relative valuations, for our purposes it does not matter.
| Country | CAPE | Shiller Earnings Yield | 10Y Bond Yield | Shiller Yield - 10 Year Bond Yield (equity premium w/o inflation adjustment) | Core Inflation | Inflation |
| Poland | 12.41 | 8.06% | 1.80% | 6.26% | #N/A | 4.70% |
| Spain | 17.93 | 5.58% | 0.45% | 5.13% | 0.20% | 2.70% |
| United Kingdom | 17.1 | 5.85% | 0.78% | 5.06% | 2.00% | 2.10% |
| Singapore | 16.6 | 6.02% | 1.52% | 4.50% | 0.80% | 2.40% |
| Germany | 22.47 | 4.45% | 0.00% | 4.45% | 1.90% | 2.50% |
| Israel | 18.18 | 5.50% | 1.14% | 4.37% | #N/A | 1.50% |
| Japan | 23.75 | 4.21% | 0.00% | 4.21% | 0.10% | -0.10% |
| Hong Kong | 20.1 | 4.98% | 1.16% | 3.82% | #N/A | 1.00% |
| Sweden | 25.44 | 3.93% | 0.33% | 3.60% | #N/A | 1.80% |
| Switzerland | 30.02 | 3.33% | -0.20% | 3.53% | 0.20% | 0.60% |
| France | 27.23 | 3.67% | 0.16% | 3.52% | 0.90% | 1.40% |
| South Korea | 18.94 | 5.28% | 2.03% | 3.25% | 1.40% | 2.60% |
| Italy | 24.75 | 4.04% | 0.90% | 3.14% | 0.20% | 1.30% |
| Australia | 23.64 | 4.23% | 1.52% | 2.71% | 1.10% | 1.10% |
| Taiwan | 32.47 | 3.08% | 0.39% | 2.69% | #N/A | 2.48% |
| Netherlands | 37.26 | 2.68% | 0.00% | 2.68% | 1.90% | 2.10% |
| Canada | 25.61 | 3.90% | 1.42% | 2.48% | 2.80% | 3.60% |
| Russia | 10.58 | 9.45% | 7.15% | 2.31% | 6.04% | 6.02% |
| China | 19.47 | 5.14% | 3.11% | 2.03% | 0.90% | 1.30% |
| United States | 37.67 | 2.65% | 1.49% | 1.17% | 3.80% | 5.00% |
| Mexico | 21.56 | 4.64% | 7.15% | -2.51% | 4.37% | 5.89% |
| India | 30.43 | 3.29% | 6.02% | -2.73% | #N/A | 6.30% |
| South Africa | 20 | 5.00% | 8.95% | -3.95% | 3.10% | 5.20% |
| Brazil | 21.58 | 4.63% | 9.24% | -4.60% | 4.16% | 8.06% |
| Turkey | 7.88 | 12.69% | 17.60% | -4.90% | 16.99% | 16.59% |
| Sources: | |
| As of Date 31/05/2021 | Barclays - Historic CAPE® Ratio by country |
| As of 24/June/2021 | 10 Year Bond Yield |
| Inflation | https://tradingeconomics.com/country-list/inflation-rate |
| Core Inflation | https://tradingeconomics.com/country-list/core-inflation-rate?continent=g20 |
Conclusion
Looking at column 5, we see that Poland has the highest score. I would discount Poland as it's a small market. Next comes Spain and the UK. Both are large markets, particularly the UK, which is one of the largest in the world. You will note that the value of column 5 for the U.S. is only 1.17%. There is not much of a premium for equity. Even Canada has more than twice the equity premium of the U.S., though Mexico is worse.
According to this analysis, India, South Africa and Brazil don't look good. I would also avoid Turkey because of the remarkably high inflation and unstable political situation.
Given the low valuations in the UK and Europe in general, I think it's worth picking up some broad market UK or Europe ETFs for one's portfolio. Other large markets like Germany and Japan also look good.
