Longstanding visitors to The Value Perspective will be aware one of our favourite valuation metrics is the Graham & Dodd PE, a long-term price/earnings ratio that, rather than referring to a single year's profit number, uses an average of 10 years to smooth out the inevitable peaks and troughs of profitability and so paint a more representative picture than any one year could on its own.
The last few months have seen some debate in the Financial Times as to the validity of a similar but inflation-adjusted valuation method – the cyclically adjusted price/earnings ratio (CAPE), also known as the Schiller PE. There are two main criticisms, the first of which is the data is too US-focused – dating, as that part of it does, back to 1881 – and thus less helpful in analysing other parts of the world.
The second criticism, which is linked, is the CAPE is set out as an absolute return rather than a relative one – and the data currently says the US market is expensive. This poses a problem for those investors who are inclined (whether by mandate or habit) to continue investing in the US and forces them to look for reasons why they can ignore the metric – why, dread words, this time it's different.
The criticism the data is US-focused is completely fair but it is that way for a good reason – the US data series is the best. It dates back the furthest by far and it has the most input from academics, but it is by no means the only market for which data exists. CAPE has been tested in a variety of international markets and so, despite the US focus, we are not reliant on US data to make the case. The UK data goes back to 1927, for example, and there is even data for various emerging markets – some countries' series being more useful than others.
The following table, compiled for IndexUniverse.com using data from MSCI and Global Financial Data, shows 10-year CAPE levels and future average real compound returns for 39 countries – ranging from the US, the UK, Germany and Japan to Brazil, Egypt, Russia and Taiwan – over the period from 1980 to 2012.
Simply put, the chart confirms what the US data has always suggested – if you buy the market when it is cheap, you will enjoy better returns than if you buy the market when it is expensive. As value investors, that comes as no real surprise to us. However, while we on The Value Perspective are big fans of CAPE and even though the above data supports our argument it is an important valuation metric, there is a caveat.
Even if the CAPE data is pointing towards investing in certain markets on current valuations, investors need to be careful about reading too much into this because often that data only starts in the 1980s. When you are using a 10-year earnings series where the data starts in 1980, say, you are effectively only considering investment returns from 1990 to today, which in market terms is really not that long and encompasses an investment environment that has been largely favourable to equities.
We believe investors would do better sticking with the US data – no matter how US-centric it may be – because the US market 100 years ago was not the developed market it is today but an emerging one. Since 1880, it has seen industrialisation, a couple of world wars, booms , busts and crashes – indeed, everything you might possible imagine happening to an emerging market, has happened to the US in that time frame.
When you use a shorter time horizon, however, it inevitably leads to skewed results. Thus, for example, the data for Japan – which only goes back to the start of 1970 – shows it to be the sixth most expensive of the 39 countries on current CAPE. Yet that is OK, one argument runs, because it trades at almost a two-thirds discount to its median valuation.
Really? The fact it is the sixth most expensive country is certainly cause for concern. That it trades at a big discount to its median meanwhile is interesting but the period since 1970, first, is not very long and, second, is one that saw the Japanese stockmarket at some extremely elevated levels. As such, even if you take the median rather than the average, you risk reaching some extremely skewed conclusions.
The US data may not be perfect but, here on The Value Perspective, we would take a longer series of data over a shorter one every time. Furthermore, just because the CAPE data for the broader selection of 39 countries does appear to work, you should always be wary of believing something just because it tells you what you want to see. When dealing with data of any kind, value investors should look to understand the numbers rather than just accepting them at face value.