The cyclically adjusted price earnings (CAPE) ratio augurs low perspective returns for U.S. stocks and improved performance for the battered and unpopular emerging markets equities. After a decade of very poor returns in emerging markets compared to the S&P500, relative valuations now favor emerging stocks to the same degree as in 2000. The following decade (2000-2010) saw strong emerging market outperformance.
The CAPE smooths out earnings by taking an inflation-adjusted average of the past ten years. It has been a popular measure with fundamental investors since the 1950s, and has been a reliable tool for forecasting long-term stock market returns. High valuations both in absolute terms and relative to a market’s history normally point to low returns in the future.
The S&P500 CAPE ratio is now the second most expensive it has ever been, only surpassed at the peak of the telecom, media and tech bubble in 2000. In line with the logic behind CAPE, in the decade after the TMT bubble the S&P500 produced negative returns for investors. During the 2000-2010 period, the CAPE ratio for the S&P 500 plummeted from 37 to 23, bringing it back to slightly below the historical average.
On the other hand, at the end of 2000 the MSCI Emerging Markets index was valued at a CAPE of 10, which was slightly below its historical mean. Over the net decade, the EM CAPE more than doubled to 20.4 and the MSCI EM index more than tripled in value.
Today, we appear to have gone full circle back to where we were in 2000. The S&P500 CAPE is once again at very high levels and the EM CAPE has returned to depressed levels. Both are near where they were in 2000.
The current condition of CAPE ratios is shown in the two charts below. The first chart shows both the present and the historical average levels of the CAPE for the EM index and most individual emerging markets and also for the S&P 500. The second chart illustrates the difference between the current levels and historical norms. Positive numbers indicate high valuations relative to history and probable low future returns.
The S&P500 is expensive in both absolute and relative terms. The S&P500 CAPE is 33% above its historical mean, which is similar to where it was at the end of 2000.
The CAPE for Emerging markets is slightly below the historical average.
In EM only Taiwan and India look expensive relative to historical CAPE norms. Of the 19 EM markets in the charts, nine are valued at 30% or more below normal.
The predictive power of CAPE ratios relies entirely on markets remaining structurally similar over time and on valuations regressing to the mean. Neither of these requirements will necessarily prevail. Market structures may change abruptly, as we have seen over the past decade in China where the index has gone from heavy in state-owned industrials to dominated by private technology companies. Also, mean regression may not occur because fundamentals (economics, politics, etc…) have changed either for the better or for the worse. Furthermore, we should expect CAPE ratios to gradually move higher because of declining transaction costs and rising liquidity.
Determining which countries deserve to be upgraded or downgraded is complicated and subjective because there are many moving parts. For example, in the case of China we can argue that slowing growth and high debt warrant lower valuations but also that the structural change of the market in favor of “growthier” private companies argues for higher valuations.
Relatively few countries have had a clearly delineated change in their fundamentals in recent years. I think a good case can be made for declining fundamentals in the following countries: South Africa, Thailand, Chile, Brazil and Turkey. These countries have had fundamental deterioration in growth prospects because of the evolution of political and economic trends, and, therefore, may not offer the upside that the CAPE framework assumes.