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Flying returns with Cape

The cyclically-adjusted price-earnings ratio is a proven way to pick winners in global markets

Investing by 'Cape' got off to a flying start in 2014. Had you bought the six stock markets trading on the lowest cyclically-adjusted price-earnings ratios at the end of 2013 - which I highlighted here last November - you would have been some 9 per cent up in sterling terms as of the start of April. Since then, however, the bottom has fallen out of this basket of cheap global indices. As of late May, the cheapest Cape markets tracked here were up by a mere 1.8 per cent in 2014 - barely better than world equities overall.

In case you missed my original articles, here's a quick recap. The cyclically-adjusted price-earnings (Cape) ratio values markets based on their inflation-adjusted earnings over the last decade. The beauty of this valuation method is that it predicts subsequent returns much better than using a single year's earnings. Specifically, low Cape ratios tend to be followed by good returns and high Capes by poor returns. The strategy in question involves splitting world stock markets into four baskets ranked by Cape at the start of each year, holding them for 12 months, and then reinvesting in the cheapest markets.

Why has the low Cape basket done so poorly of late? In a sense, this should not worry us too much. The essence of buying low Cape markets is to invest in the cheapest markets at the start of each year and then sit on them for 12 months. As of now, we're barely halfway through the year. So, there is still plenty of time for the cheapest markets to do their stuff.

Dear Cape struggles again

Cape investing has paid off in at least one way in 2014 so far. Dear Cape markets have been the worst performing of the lot, lagging behind all of the other three baskets and world stocks in general. This is wholly in keeping with what has happened over time. Since 1982, buying the most expensive Cape markets each year has done worse than buying any of the other three baskets or indeed buying and holding world equities in general.

While investing in a low Cape basket was the best strategy in 2013, it was the worst in 2011 and 2012. In each of those years, the better approach was to buy into the second-cheapest basket of Cape stocks. Second cheapest has also been runner up in terms of performance over time, as the accompanying chart shows. An investment in the lowest Cape countries every year since 1983 would have compounded at 10.4 per cent a year after inflation but not adjusted for exchange rates, compared with 7.3 per cent for the second-cheapest basket.

Source: Thomson Datastream


Something really held back the performance of low Cape in 2014 to date was exchange rates. I've calculated the returns for recent months from the point of view of a UK investor, in sterling. Since the basket is dominated by eurozone stock markets, the returns were dragged down by the euro's recent weakness against the pound. If you hedged your currency risk, the portfolio would have been up by 10 per cent at its best point and would still be ahead by around 4 per cent today.

Current Cape Crop

The Cape strategy addressed here involves a once-yearly rejig of the basket. Changes that happen during the course of the year do not lead to any changes in the make up of the basket. It's the state of Cape at the time of rebalancing that counts. However, it is worth keeping an eye on the state of Cape in the meantime for clues as to what's happening. Right now, the cheapest markets are Austria, Italy, the Netherlands, Singapore and Finland and Spain.

If you are thinking of investing in these areas, the most important issue is how to manage the exchange rate risk. With the European Central Bank set to cut rates and perhaps ultimately to print money, the euro may well have further to fall against the pound. Hedging the currency exposure of this portfolio is therefore definitely to be considered.


Latest Cape

Datastream indicesCape 19/05/14
Hong Kong13.5
South Korea14.3
New Zealand16.4
South Africa18.3

Source: Thomson Datastream


To hear more about the use of Cape in investing in global stock markets, you can watch my latest video with top US investment manager Meb Faber, including his take on the dearest markets right now: