Does CAPE Work For Emerging Markets?

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are usually accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side and the CAPE has proven effective in highlighting them.

The CAPE (Cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

The charts below illustrate the relationship between stock market total nominal returns and the level of the CAPE ratio for Global Emerging Markets, the S&P500 and 18 emerging markets. The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country data is more significant because the CAPE ratios capture better the evolution of the single asset.

CAPE works particularly  well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia); less well for more stable economies (eg, East Asia).

1. S&P 500 :  The market has not provided 10 year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2021 was 39.3, the second highest in history.

2. All date points, including GEM and 18 countries: This is a very noisy graph  but the trend is clear. All 10 year periods with returns at least 15% annually started with CAPE below 25.

3. Global Emerging Markets: Clear trend.  GEM has never returned less than 10% annually with cape below 10; returns have never been above 5% with CAPE above 20. GEM CAPE ended 2021 at 14.4.

 

4. China: All high return years started at CAPE below 10; all low returns started at CAPE above 20. China end 2021 at 13.3.

 

5. India: India performs best with CAPE below 20 and really struggles above 25. 2021 ended at 31.1 which should weigh heavily on future returns.

6. Korea: Clear trendline but slightly more dispersion than in most other markets. Current CAPE is 9.6.

7. Taiwan; All high return decades have started with CAPE  below 15; low returns have started above 20. The current level is 27.1, the highest since the Taiwan bubbles of the 1990s.

8. Brazil: Brazil is a good example of a highly cyclical economy prone to boom-bust cycles and unstable liquidity flows. A CAPE of 15 seems to be the dividing line for returns, with equity booms starting with CAPES in the low teens and the market struggling with CAPES in the high teens.  At the current CAPE of 10.9, the market is priced to provide high returns.

9. Turkey: Annual returns have been very high when CAPE has approached the five level, and very poor when CAPE reaches the high teens. The current CAPE of 4.1 is the lowest since the early 1990s. This is the fourth time that CAPEs have been below five and on every occasion very high returns have followed.

10. Mexico. Current CAPE is 18.2

 

11. Philippines

12. Thailand

13. Russia

14. Malaysia

15. South Africa

16. Indonesia

17. Peru

18. Chile

19. Colombia

20. Argentina