Swedroe: A Closer Look At CAPE Ratio

March 28, 2014

Shiller’s CAPE ratio has predictive value in developed and emerging markets, Swedroe says.

When estimating returns, we know that current valuations provide valuable information.

The earnings yield derived from the Shiller CAPE 10—the cyclically adjusted price-to-earnings ratio—is considered by many to be at least as good, if not better, than other metrics. It uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle.

The research shows that valuation metrics such as the CAPE 10 explain about 40 percent of real (after inflation) 10-year returns. However, it’s also important to note that the CAPE 10 provides no value forecasting short-term returns. In fact, the correlation with one-year-ahead returns is close to zero.

Joachim Klement, author of the 2012 study “Does the Shiller-PE Work in Emerging Markets?” examined whether Shiller’s CAPE 10 worked as well in emerging markets as it does in the U.S. and other developed markets. Klement examined the data from 19 developed markets and 16 emerging markets.

The longest data series for the developed markets were the U.S. (1910), the U.K. (1937), Canada (1965), and Japan (1966). The shortest were Austria (1991) and Ireland (2000). The longest data series for the emerging markets were Malaysia (1982), South Korea (1984) and Thailand (1985), while the shortest were for China and Columbia, both 2005.

The relatively short data series does present a problem in analyzing the data in the emerging markets, since you need at least 10 years of history. And the short history means we have lots of overlap in the data.

In addition, in many cases, the data doesn’t cover full economic cycles. Thus, there is a lot more uncertainty in interpreting the results for emerging markets than for the developed ones. With that caveat in mind, the following is a summary of the author’s findings:

  • There is a logarithmic relationship between the Shiller CAPE and future real returns across markets.
  • The Shiller CAPE 10 has little explanatory power at short horizons, but correlations rise as the horizon increases. Where the data is available, the correlation at 20 years is around 0.7.
  • The explanatory power of the CAPE 10 for some emerging markets is similar to developed markets, while for emerging markets as a whole, the explanatory power of the CAPE 10 is much less than for developed markets as a whole.

The fact that the explanatory power is less for emerging markets shouldn’t come as a surprise as we would expect that the time-varying risk premium equity investors require would be higher in the emerging markets. In addition, the data series is very short.



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