Swedroe: A Closer Look At CAPE Ratio

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.

To increase the data set, Klement also looked at the predictive power of a CAPE 10 over five-year horizons. Doing so, he found that correlations within markets were the same for developed and emerging markets at 0.32. He also found that for the overall developed markets, the correlation was 0.28 and 0.18 for the emerging markets.

Summarizing, while the data series is relatively short, the Shiller CAPE 10 does seem to provide us with information on future returns for developed as well as emerging markets. With that in mind, let’s take a quick look at expected returns based on this metric.

Because the CAPE 10 is based on the last 10 years of earnings, we’ll adjust the earnings yields to take into account the five-year average lag. Using the historical real EPS (earnings per share) growth rate of 1.5, you multiply it by 5, again, to take into account the lag. You might think we’d multiply 1.5 by 5 and end up with 7.5, but that’s not quite right. As I said, we need to adjust the earnings yield, and to do that, the current earnings yields will actually multiply by 1 + .075 = 1.075.

The reason behind this is that because Shiller adjusts earnings by inflation, there’s no need to do an inflation adjustment to equate 2004 earnings to 2013 earnings. However, earnings do tend to grow over time, and the Shiller numbers make no adjustment for this. You need to adjust the earlier earnings, taking into account this growth.

With the equation figured out, as of the end of January 2014, the current earnings yields were 5.94 for the MSCI EAFE Index and 6.64 for the MSCI Emerging Markets Index. Accounting for the lag adjustment (or multiplying 5.94 and 6.64, respectively, by 1.075) increases those yields to 6.39 percent for the EAFE Index and 7.14 percent for the Emerging Markets Index.

As of the end of February 2014, the CAPE 10 ratio for the S&P 500 Index was 25.65. That results in an earnings yield of 3.90 percent, and an adjusted earnings yield of 4.2 percent.

What we see is that the recent strong performance of the U.S. market has driven the CAPE 10 up, and expected returns down. On the other hand, the poor performance of the emerging markets over the past two plus years has resulted in higher future expected returns.

Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.