Using CAPE Ratios in 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 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. The Cyclically Adjusted Price Earnings multiple (CAPE) has proven effective in highlighting them.

The CAPE 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.

CAPE is best used as a long-term allocation tool. However, it is not effective  as  a timing tool. Market timers seeking short-term returns will be more successful using traditional technical analysis to identify trends and paying close attention to investor sentiment and liquidity flows.

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

In recent years CAPE has  has been ineffective in predicting forward annual returns. This has occurred because momentum has been more important in determining stock performance than valuation indicators. Moreover, emerging markets started the past decade at very high valuations, and only recently have come to trade at cheap levels and, in some cases, extremely low valuations.

Since  October 2020, we have seen a marked change in the investment environment, with the value factor in both U.S. and international stocks starting to outperform “growth” stocks. Emerging market value stocks have outperformed the EM index by over 20% during 2021-2022. Also, by and large, “cheap” CAPE stocks have started to reward investors. The cheapest stocks on a CAPE basis at the end of 2021 (Turkey, Chile and Brazil) all performed exceptionally well in 2022.

In the charts below we see  what CAPE ratios are currently telling us about future returns based on historical precedents. We map index returns and CAPE ratios for the U.S., GEM (Global Emerging Markets) and the most important emerging market countries (China, India, Taiwan, Korea and Brazil) and also for several countries of interest (Turkey, Philippines and Mexico). 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 specific data is more significant because the CAPE ratios capture better the evolution of the single asset.

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 2022 was at 27.3, a level which suggests moderate nominal returns in the low single digits for the next 7-10 years.

2. Global Emerging Markets. At the current level (15.4) the GEM CAPE provides little insight. The probability of negative or high returns both appear to be low. GEM should be bought below 15 and sold above 20.

3. China’s short and turbulent stock market history provides few data points for CAPE analysis. Nevertheless, the current CAPE (9.5) has provided high returns in the past and points to low risk of negative returns. Chinese stocks should be bought below 12 and sold above 20.

 

4.India: The CAPE for India (25.6) is high both in absolute terms and relative to the country’s history, reflecting a good GDP growth profile in a world with scarce growth and investor enthusiasm. At this high level  return prospects are poor and negative returns are a distinct possibility. Indian stocks should be bought in the high teens and sold in the high twenties.

5. Brazil: At the current CAPE (9.4) history points to potentially high returns, but not without risk of disappointment. The ideal entry point for Brazil is below 8 and the market should be sold around 18.

4. Korea: The CAPE for Korea (6.4) is low both in absolute terms and relative to the country’s history. At this CAPE level high returns are likely and negative returns are a low risk. Korean stocks should be bought below 10 and sold in the high teens.

5.Taiwan: The current CAPE for Taiwan (14.9) is cheap. Future returns appear attractive but Taiwan has a turbulent stock market history, a highly cyclical market and geopolitical risk, so caution is advised. Taiwan should be bought below 15 and sold above 20.

6.Mexico:The CAPE for Mexico (15.3) is in neutral territory, implying fair valuation. The market should be bought in the low teens and sold in the mid twenties.

7. Philippines: The current CAPE (13.1) is on the low side and offers the prospect of high returns with some risk. The market should be bought below 15 and sold above 25.

8.Turkey: The current CAPE (6.9) is low in absolute terms and relative to the country’s history and offers the prospect of high returns, made more likely by the recent momentum. Nevertheless, this is  always a very risky market with turbulent macroeconomics and politics and short cycles. This market should be bought below 10 and sold above 15.