As I have stated in the past I use the Cyclically Adjusted Price to Earnings (CAPE) ratio as a tool to determine undervaluation and overvaluation of various stock markets around the world. The reason I do this is because plenty of research and back testing has been done that shows that buying when markets are out of favor leads to investing outperformance.
I was introduced to this tool and investing methodology by reading various books written by Meb Faber. Mr. Faber is the CEO of Cambria Advisors and has written both books and white papers on investing. He also has a weekly podcast which I highly recommend.
In the introduction to Mr. Faber’s podcast you will hear him say “…. join us as we discuss the craft of investing.” This struck me and made me think. Investing successfully is a craft or skill. Most people think they can be good investors but in fact we know from research that most individual investors that actively manage their own money severely underperform the market.
People hear about great investors or read an article about Warren Buffet and think hey I can do that. They do not realize that successful investors are highly skilled and disciplined in what they are doing. Most people cannot be a successful investor just like most people cannot be a vascular surgeon.
I would say that 99.9% of the people should just dollar cost average into a low cost index fund like those offered by Vanguard. Just put $200 per pay period into the fund every week, regardless of what the market does, for forty years and you will have a nice nest egg. However, most people will screw that up because they will see what happened last week and sell! That’s another story.
Mr. Faber wrote a white paper entitled, “GLOBAL VALUE: BUILDING TRADING MODELS WITH THE 10-YEAR CAPE.” Go read this white paper as it explains the methodology of properly using CAPE as a tool. It is not the only tool I use, just like you can’t build a house with one tool, but it is one of the most important.
Because the market in the US has risen so much over the last year or so many people have poo pooed the CAPE ratio. The argument goes, “The CAPE ratio has indicated that the market has been overvalued for year. If we listened to it we would have missed out on all these gains. Ergo the CAPE ratio doesn’t work.”
I have read plenty of people that have researched CAPE and not one has suggested it is a market timing tool. Like I said earlier it is one tool in our tool box that we use to build and manage a successful portfolio. Faber address this in his paper,
“valuation is best used as a strategic guide rather than as a short-term timing tool. It is most useful on a time scale of years and decades rather than weeks and months (or even days). While we can formulate a hypothesis for where the S&P 500 should͛ be trading, the animal spirits contained in the marketplace invariably cause prices to deviate quite substantially from reasonable͛ levels, often for years and even decades.”
I will continue to use CAPE as it has worked for me. Below are the updated CAPE ratios for most overvalued and most undervalued. Ideally one would be lessening exposure to overvalued and cycling that money into undervalued areas.
Undervalued:
1. Russia
2. Czech Republic
3. Portugal
4. Spain
5. Poland
6. Brazil
7. Italy
8. Egypt
9. Greece
10. Singapore
Overvalued:
1. Denmark
2. US
3. India
4. Ireland
5. Switzerland
6. Philippines
7. Netherlands
8. Peru
9. Indonesia
10. Sweden
I wrote a more in depth article on CAPE and how I use it which you can read here.
You can track CAPE ratios at these sites:
Interactive Research Affiliates link
Star Capital link
You will note there are some slight variations between the various parties as many people also use other metrics and try and come up with a weighted rating.
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