Measuring International Equity Returns with the CAPE Ratio
How to Calculate & Use the CAPE Ratio to Improve Returns
Investing in frontier and emerging markets is often much riskier than investing in domestic markets for U.S.-based investors, with factors like political risk and currency risk affecting equity valuations in a big way. In order to justify these added risks, investors must ensure a sufficiently high level of expected returns, driven by rapidly growing economies, favorable demographic trends, and other factors, relative to the United States.
The bad news is that expected returns are equally difficult to project in many cases, given the large number of influencing factors. For instance, many frontier and emerging markets are dependent upon exports in order to drive economic growth, which means that their gross domestic product (“GDP”) is largely dependent on external consumer spending. Governments and companies have little control over these types of driving factors.
In this article, we’ll take a look at how to measure expected returns using the cyclically adjusted price earnings ratio – or CAPE ratio – that measures long-term potential.
Calculating the CAPE Ratio
The cyclically adjusted price earnings ratio – or CAPE ratio – is calculated by dividing the current price of a broad stock market index by the average inflation-adjusted earnings of its components over the past 10 years. Often times, an inflation multiplier is applied to each year’s earnings per share before dividing the total by 10 (to get the average) in order to simplify the process – since inflation multipliers are widely available for reference.
The CAPE ratio requires at least 10 years of historical data, which can be difficult to come by in many countries. Among developed nations, the U.S., U.K., Canada, and Japan had the longest track records, while Austria and Ireland had the shortest. Emerging markets like Malaysia, South Korea and Thailand also have long track records, while China and Columbia have only been recording that necessary data since around 2005.
Using the CAPE Ratio
An S&P 500 CAPE ratio of less than 10 produced 10-year returns of over 16%, while a ratio over 25 produced returns of less than 4%, according to several studies of the U.S. market. In fact, the effect is so strong that several exchange-traded funds (“ETFs”) were launched to capitalize on changes in the CAPE ratio as a whole and between industry subsets. For instance, Ossiam launched at ETF focused on the concept using sector rotation.
The same metric can be applied to frontier and emerging equity indexes to determine their valuation relative to historical norms. In general, a CAPE ratio of between 10 and 15 is considered ideal, while a ratio over 20 could indicate that the market is overvalued and could be due for a correction. It’s worth noting, however, that different markets have different absolute readings, so investors should also take a look at the bigger picture charts.
Researching CAPE Opportunities
International investors can quickly find CAPE ratios for various countries around the world using free tools like Star Capital’s Global Stock Market Valuation Ratios. As of Q1 2015, the cheapest countries in the world were Italy at 12.9, Spain at 13.5, and Norway at 13.7, as well as developed Europe and emerging markets at 16.5. There are also tools, such as CAPERatio.com, which can help calculate the metric for individual stocks within a market.
When using the CAPE ratio, investors should look for confirmations through a variety of other indicators rather than relying on it exclusively. Many investors prefer to use the CAPE ratio to screen for countries or industries that are trading at a discounted valuation and then look for compelling individual opportunities within those countries using American Depositary Receipts (“ADRs”) or by purchasing foreign stocks directly.
Key Takeaway Points
- Investors in frontier and emerging markets face much higher risks than domestic markets given political and currency risk factors.
- The CAPE ratio can help ensure that potential long-term returns ahead will be sufficient to offset those higher risks.
- Investors should use the CAPE ratio in conjunction with other forms of analysis rather than relying on it exclusively.