CAPE Ratios: How much weight should we assign to them in choosing markets?
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CAPE Ratios: How much weight should we assign to them in choosing markets?
Posted by NC_Tigah on 8/6 at 12:13 pm
Cyclically-adjusted price-earnings ratios (CAPE) seem to be a popular measure of stock market value. Analysts, e.g., Mebane Faber, apply CAPE to international markets, and rank resultant global comparisons. There's presumed importance relative to prospective market performance. The numbers below are from April.

From a risk stance, market/national stability is an obvious governor. For example, I wouldn't be trading US positions for Greece on this info, but Germany at 14 vs the US at 22.5 (even given the EU situation) gets my attention. Just curious as to thoughts here re: weighting or importance of the comparisons.








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Posted by Doc Fenton on 8/6 at 12:42 pm to NC_Tigah
quote:

Cyclically-adjusted price-earnings ratios (CAPE) seem to be a popular measure of stock market value.


Well yeah, according to the Wikipedia entry for CAPE ratio, the idea is at least as old as Benjamin Graham's Security Analysis, although the specific term "CAPE" usually refers to Bob Shiller's 10-year methodology.

Obviously you don't want to use P/E ratios based on a single data point, since that leads to meaningless statistics in a similar vein to my greatest pet peeve of financial media reporting, the infamous "corporation X increased profits by 2,584.32% last quarter!" (so what?).

But how you want to smooth out past earnings, and/or blend it with estimates of future earnings, is more art than science.

This gets into the similar issue of using PEG ratios, which adjusts P/E ratios for expected growth (since rational investors will bid up prices to higher P/E ratios when expected CAGR's for earnings are higher).

But then how do you estimate future growth? Not only for a single corporation but also for a particular country's stocks? (And for that matter, how do you know how much a particular country's stocks will branch out into emerging markets, capturing equity from foreign subsidiaries?)

How do you use common sense and say something like "the last 3 years aren't very characteristic of future earnings," or something similar?

It has to do with experience, gut, intuition, common sense, and all that jazz.

ETA: And related to this...

quote:

Just curious as to thoughts here re: weighting or importance of the comparisons.


The way I look at them, P/E ratios are pretty much everything when it comes to investment allocation across large asset classes (as opposed to say doing CAPM or APT or Fama-French calculations for alpha for some high-low strategy within a particular sector, or DCF/NPV calculations for a very specific project) ... once you've worked out all the necessary adjustments.

You adjust P/E ratios for smoothing to make then CAPE ratios. You adjust them for future growth estimates to make them PEG ratios. You can adjust them for expected volatility in earnings or in foreign exchange rates (LOLZ Argentina). But once you do all these adjustments, you should theoretically have a pretty clear metric for which class of equity has the most attractive price (even if your estimates for guessing what that metric is are necessarily very rough and back-of-the-envelope-esque).

EDIT2: It looks like an excellent time to go enable some Zionists...

quote:

Israel 11.32




This post was edited on 8/6 at 1:19 pm

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Posted by tirebiter on 8/6 at 12:49 pm to NC_Tigah
Other than momentum factors it makes sense to at least consider PE10, especially if you have already won the game. Doesn't mean the market can't keep crawling higher for a few years, but for longer term results I like investing in less costly securities not more expensive, especially if one believes in reversion to the mean. One reason why rebalancing can make a lot of sense. Ben Graham 25-75 mantra would come into play. It's not like 1999-2000 at this point by a long shot, though, plus ZIRP continues.


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Posted by NC_Tigah on 8/6 at 1:31 pm to Doc Fenton
quote:

Bob Shiller's 10-year methodology
Right.
Faber's schtick is application of Shiller's PE ratio calcs (first applied to the S&P) to various international indices. Fortune had a nice write up on it recently (can't find it online though).

Was surprised at some of the market-to-market CAPE disparities. Will probably use new purchases to rebalance a bit toward non-emerging foreign markets.
quote:

EDIT2: It looks like an excellent time to go enable some Zionists...



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Posted by Doc Fenton on 8/7 at 5:03 am to NC_Tigah
quote:

Will probably use new purchases to rebalance a bit toward non-emerging foreign markets.


Okay, but just keep in mind that CAPE ratios are supposed to be lower here, since non-emerging foreign markets are notoriously sluggish with respect to long-term growth, market demographics, public indebtedness, etc.

Anyway, I just came across this article from RealClearMarkets.com earlier this morning on Grantham's methodology: " This fund tracks 36 bubbles—and 33 have completely popped."

quote:

When writing an article on the slowing pace of global growth last week—for which Grantham’s ideas provide significant fodder—my colleagues and I were spellbound by one statistic: of the 36 major bubbles GMO says it tracks, 33 have completely popped, or returned to their prior trends.

GMO won’t say what most of these are, and according to the firm’s quarterly letters, it also tracks a lot more less-major bubbles: 330 by its February 2013 count. For GMO, a “bubble” is simply when the price of an asset in relation to its real value (usually just the “price-to-earnings ratio” in investor-speak) has exceeded its average by a certain amount, and a “major bubble,” a bigger amount (two standard deviations, for statistics aficionados.)


quote:

GMO declined to provide more details about its methodology or current bubbles it’s tracking because those data are proprietary.



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Posted by C on 8/7 at 6:24 am to Doc Fenton
quote:

of the 36 major bubbles GMO says it tracks, 33 have completely popped, or returned to their prior trends.


This seems 100% worthless. Bubbles happen when people expect future increases in earnings (or worth). So of course it will eventually reach a balance of meeting prior worth trends or not. When has a bubble existed in perpetuity?



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Posted by NC_Tigah on 8/7 at 5:06 pm to C
quote:

Bubbles happen when people expect future increases in earnings
Yep.


All in a seeking alpha continuum:

5yr comparisons of S&P, EU350, Emerging Mkts, China



quote:

‘China screamingly cheap’: Strategist

CNBC.com | Wednesday, 7 Aug 2013 | 1:13 PM ET

Growth in China is strong enough to support specific stories, JPMorgan Private Bank Chief Investment Strategist Kate Moore said Wednesday.

"We still like stocks. We're 'overweight' equities for the first time in several years, and we have high conviction that equities are going to outperform over the next 12 months," she said. "We're 'overweight' the U.S., and we really like U.S. stocks, but I think that's a very consensus call. I think everyone I know is long U.S. dollar assets, is long U.S. large-cap equities, maybe they're sniffing around small caps."

On CNBC's "Fast Money," Moore added that it was time to look outside the United States for continued gains, specifically "in Europe, in Asia and Japan, and looking for good value."

"China is screamingly cheap," she said. "It's at 8½ times forward earnings. It's about a 40 percent discount to developed markets. It's a gigantic 2½ standard deviations cheaper than it historically is, even to developed markets.
"We think a lot of bad news is in the price."



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Posted by Doc Fenton on 8/7 at 11:03 pm to C
Good God. I hope you're joking.


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Posted by Doc Fenton on 8/7 at 11:05 pm to NC_Tigah
quote:

It's at 8½ times forward earnings. It's about a 40 percent discount to developed markets.


For a good reason.

It may work out, but there is enormous risk involved with China.



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Posted by foshizzle on 8/8 at 6:39 am to NC_Tigah
Do these comparisons use the same definition of earnings regardless of country? Accounting rules do vary somewhat after all.


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Posted by C on 8/8 at 6:42 am to Doc Fenton
quote:


Good God. I hope you're joking.


100% not, just ignorant apparently. Please school me on the history of bubbles.



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Posted by NC_Tigah on 8/8 at 8:13 am to foshizzle
quote:

Do these comparisons use the same definition of earnings regardless of country? Accounting rules do vary somewhat after all.
Correct.
Faber notes the same. Indicates he tries to account for those variances. But there is likely some inherent error rate in the numbers. Presumably it's small.



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Posted by Doc Fenton on 8/8 at 11:33 am to C
I agree with you on bubbles, but I think you were missing the larger point about what Grantham was doing. They are in the business of identifying bubbles, and the info that 33 of their 36 identified bubbles popped is thus not worthless, because it indicates that they do in fact know how to identify bubbles.

Everybody knows what happens to bubbles with perfect hindsight. And yeah, there's another issue about people knowing that they are in a bubble and buy anyway in an attempt to time things correctly, but given how many different P/E aberrations that Grantham identified, I don't think we need to get too technical about what the exact definition of a "bubble" is. Let's just say that GMO appears to be providing value by identifying which asset trends are about to revert back toward their averages.

Also, my apologies for my flippant rudeness. I need to stop being so unnecessarily combative with my posts all the time.



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Posted by C on 8/8 at 12:01 pm to Doc Fenton
quote:

my apologies for my flippant rudeness.
no worries

quote:

They are in the business of identifying bubbles, and the info that 33 of their 36 identified bubbles popped is thus not worthless, because it indicates that they do in fact know how to identify bubbles.


When I hear a bubble popped, to me that means that it crashed because nothing was behind the enthusiasm warranting the increased value. But the part about returning to their prior trends could mean the P/E actually increased to a value meeting expectations. And since they won't say what they are, I'm a bit sceptical.

So when is a bubble not a bubble?




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Posted by NC_Tigah on 8/8 at 12:35 pm to Doc Fenton
quote:

apologies for my flippant rudeness. I need to stop being so unnecessarily combative with my posts all the time.

You're about the least flippantly combative poster on the board Doc.



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Posted by Doc Fenton on 8/8 at 1:45 pm to C
quote:

So when is a bubble not a bubble?


There are so many ways to answer this, but I don't want to get caught in a game of arguing over different people's definitions. I will say that the GMO people seem to be a little cavalier with their use of the term, but that's just a marketing thing I guess.

quote:

But the part about returning to their prior trends could mean the P/E actually increased to a value meeting expectations. And since they won't say what they are, I'm a bit sceptical.


Yeah. You have to be when people won't give out the proprietary information.

When are P/E's really out of whack, and when are they just indicative of future expected growth that is genuinely about to take off? GMO claims they have the answer.... you just have to pay them a bunch of money for them to give you the details.



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