Attractive global returns for the patient investor

We talked about earnings yield in Where should I invest?. When it comes to stocks and stock markets, the Shiller PE ratio (also called the CAPE ratio) is a good way to measure earnings yield:

Estimate of earnings yield = (100 / Shiller PE ratio) %

Higher the CAPE ratio, lower the earnings yield. For a long-term investor, higher earnings yield is obviously more attractive. In a number of works published in the 80s and 90s, e.g., Stock prices, earnings, and expected dividends, researchers illustrated that high stock market earnings yield is generally followed by good market performance and vice versa.

One point worth noting is that Shiller PE is not very good for predicting short-term returns or for timing market crashes. The predictive ability improves when the forecasting period is longer, e.g. 5 or 10 years. This has been demonstrated, e.g., in the paper Dividend yields and expected stock returnsA high Shiller PE (low earnings yield) generally means that a country’s stock market is overpriced, and investing in that country will probably lead to disappointing results eventually. However, it does not guarantee that the country’s stock market will do badly next month or next year. A richly valued stock market can continue to become more richly valued for several years, eventually turning into a stock bubble before it crashes. This happened in the late 90’s when the US stock market became heavily overpriced, a phenomenon attributed to irrational exuberance.

Investing in a basket of countries with low Shiller PE ratios generally leads to higher returns, a result demonstrated convincingly in a number of publications, e.g., the paper Global Value. Conversely, countries with high Shiller PE ratios exhibit poor returns over the subsequent 10-year period.

Shiller PEs and other country stock market valuation metrics are posted quarterly on Star Capital. They recently posted an update showing that performance of stocks in different countries corresponded well with their Shiller PE based predictions in 2016. Russia, the country with the lowest Shiller PE posted returns of 37% (in ruble) and 58% (in US dollar) in 2016. Russia doesn’t sound like a safe place to invest. And that’s generally true of countries with low Shiller PE ratios. CAPE ratios in the neighborhood of 5 signal extreme distress or significant risk factors. Risk factors include the risk that foreign investors may lose all their money or that a country’s currency may go to zero. However, such terrible outcomes are rare enough that investing in a diversified basket of cheap countries produces high returns with high probability in the subsequent 5-year period. While it is no doubt daunting to invest in such countries, I remind myself that historical studies take into account periods of far greater uncertainty than today, including World Wars where most countries were direct or indirect participants.

As of the day of this posting, the US stock market is quite expensive with a Shiller PE of around 28. This is just under double the historic mean and median of around 16. However, this doesn’t mean that a market crash is imminent. I’ve provided one reason above – that overvaluation is a poor market timing instrument. There’s also another reason having to do with opportunity cost, an idea labeled as the equity risk premium. The Shiller PE corresponds to a 10-year average earnings yield for stocks, and I find it helpful to compare this with the 10-year treasury rate. Since stocks carry much more risk than treasuries, it is reasonable to expect that the earnings yield of stocks will be higher than the treasury yield to compensate for the higher risk, the difference of the two being the equity risk premium. In 1929 before the great depression, and in the late 1990’s before the dot-com bust, the 10-year earnings yield of stocks  went lower than the 10-year treasury’s yield, signaling extreme overvaluation. The US stock market has an earnings yield of 100/28 or about 3.6% now. This is clearly still higher than the yield of the 10-year treasury, currently at 2.4%. The difference gives us a roughly calculated equity risk premium of 1.2%, low by historical standards but still positive. In other words, high stock valuation is being supported by low interest rates. If the Fed were to raise rates rapidly, stocks would start to look less attractive, but we’re not there yet.

A note for those who follow the SciPre portfolio: Many countries in the SciPre portfolio have low Shiller PE ratios. Their undervaluation is an important factor contributing towards their inclusion in the portfolio.

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