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Global Value: The CAPE Ratio

Bubbles and investor emotions were the subjects of the first two chapters of "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market." Obviously, neither bubbles nor an excess of emotions is good for investment decisions.

So in chapter three, Mebane Faber turned to possible solutions. There are several of them, and he began by pointing out that following an investment plan would help investors avoid emotions. But what should be in that investment plan?


He wrote of using the buy-and-hold technique, in which an investor commits to a particular stock or group of stocks for the long term. Once the initial decision is made, the investor then holds the stock indefinitely; Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) are famous for taking this approach. Few of us are likely to be as patient as Buffett when going through bubbles and busts, however, so Faber considered this strategy to be of limited value.

What about buying and selling according to valuations? Faber argued it is better to think of valuation as a strategic guide rather than a tool for timing entries and exits. It's possible to come up with a price at which we think the market "should" be trading, but the animal spirits have minds of their own.

To avoid the pain of bubbles and emotions, the author recommended what he called a "simple model," which is the cyclically adjusted price-earnings (CAPE) ratio. It began with Benjamin Graham and David Dodd; in their 1934 book, "Security Analysis," they introduced the idea of smoothing out earnings over multiple years (preferably five to 10 years). By using multiple years, they were able to smooth out the business and economic cycles and price fluctuations.

In 1998, Robert Shiller, the Yale economist and Nobel laureate, formalized that idea in a paper, "Valuation Ratios and the Long-Run Stock Market Outlook" and a book, "Irrational Exuberance." The latter made Shiller something of an economic prophet. In his book, which came out shortly before the dotcom crash, he warned that stocks were overvalued.

What is the CAPE ratio? It describes the price-earnings ratio over 10 years, rather than on a particular date (which is what the traditional price-earnings ratio does). Also known as the Shiller P/E, or P/E 10, it is calculated by dividing the price of a stock by its average earnings over the past 10 years, adjusted for inflation. It can also be used on an index such as the S&P 500.

For more on the CAPE ratio, Shiller maintains a website that provides extensive information and historical data, as well as information on how he constructs the ratio (according to his website, he introduced a variation on the CAPE ratio in 2018). And, at GuruFocus, see my review titled, "Modern Value Investing: CAPE and Long-Term Investing."

GuruFocus also has a page dedicated to the Shiller P/E, or CAPE. This is the reading for the SPDR S&P 500 (SPY) exchange-traded fund at market close on Feb. 14:

From this page (ignore the reference to March 1, 1958), we learn that:

  • The CAPE ratio at closing on Feb. 14 was nearly twice as high as its long-term average of 17. At a level of 32.3, the ratio was almost double the long-term average, specifically 90% higher.
  • Only three times in the past 140 years has the CAPE ratio been higher than it was last week, 1929, early 2000 and Sept. 1, 2018, when it hit 32.60. As the chart shows, the first two spikes were followed by serious corrections.



Getting back to Faber's book, he studied all CAPE ratio data from 1881 to 2011, along with real 10-year forward returns (real equates to after inflation). The relationship is clear and important:

  • When the CAPE is less than 10, returns have historically averaged more than 10% per year.
  • When the CAPE is between 10 and 15, returns are less than 8% per year.
  • When the CAPE is between 15 and 20, returns average about 5% per year.
  • When the CAPE is between 20 and 25, returns average less than 3% per year.
  • When the CAPE is greater than 25, returns average less than 1% per year.



Faber summarized: "What we find is no surprise: It very much matters what price one pays for an investment! Indeed, it is an almost perfect stair step - future returns are lower when valuations are high, and future returns are higher when valuations are low."

If I look at this information from a value investor's perspective, it is clear that buying at a discounted price is essential because price is one of the two numbers from which the CAPE is calculated. Earnings are also important, but if you pay too much for them, your odds of success are limited.

Conclusion

Over the first three chapters of "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market," Faber has led us through a brief history and analysis of stock market bubbles, investor emotions that can lead to or intensify a market boom and now a tool that can help us avoid getting caught up in bubbles.

Further, his research has shown a direct relationship between the levels of the CAPE and the kinds of returns investors can expect. Simply put, expect higher returns when the CAPE is lower and vice versa.

Lest we think the CAPE ratio is a panacea for investors, there are many critics, and Faber discusses their arguments in a future chapter.

Disclaimer: This review is based on the book, "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market" by Mebane (Meb) Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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This article first appeared on GuruFocus.