21st Apr 2020 by Josh Matthews, HBA

Valuations: Assessing the change


Market Commentary  

A month feels like an eternity in today’s unparalleled environment – markets sold off at a faster rate than at any point in history, they found a base and then bounced back. This was entirely due to the necessary fiscal and monetary stimulus from Central banks. Many people are asking themselves if it is a good time  to buy equities given current valuations? To be able to identify cheap or expensive equity markets, investors must, amongst other things,  look to  analyse and interpret the market and consider valuation ratios that compare fundamental data for equity indices such as book value or earnings with current prices (P/E or P/B).

Various valuation ratios exist, and each comes with its benefits and deficiencies (such as having no predictive power in the short term). One ratio MASECO takes most guidance from, because  of its reasonable ability to predict long term (10y plus) equity returns, was developed by Campbell and Shiller in 1988: the cyclically adjusted price-to-earnings ratio (CAPE). It looks at a business’s  current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year period is to ensure that the profits are averaged over more than one business cycle and to account for different levels of inflation over the period. 
Is the US equity market still expensive?

In the chart below, one can see that the average US CAPE since 1880 was 17. Its latest reading as at the end of March 2020 was 24.6 having fallen from 30.6 just 2 months earlier.

US Cape 1880-2020 

Source: Yale University. March 2020 

As one can see these CAPE numbers are above the long-term average. US equities have seemed expensive for the past few years and therefore most investors would see them as still being overpriced. There is an argument that a higher average CAPE is justified because we now live in a world of low interest rates however even if one takes this into account US equities are still looking dear. 

Expected returns for US equities have increased from a low level 

The good news is that it is possible to infer long-term return expectations from the assumption that CAPE returns to its long-term average. The bar charts below show the implied level of CAPE and implied long-term expected return at various levels of draw-down from the S&P 500’s peak of 33.86 on February 19th April 2020. A 30% equity market pullback implies a CAPE level near 22 and an increase in expected return of 1.7% a year for the next decade because of lower valuations.

This assumes  a long-term fair value multiple of 17. For investors who believe that  fair values multiple to be higher than 17 (because of lower interest rates today) these expectations will differ, but the point remains the same—the market’s drop translates into higher expected returns. 

CAPE and Expected Returns Estimates at Different Market Prices 


Source: Research Affiliates, April 2020 

Investing always means you chose to buy one thing instead of another  and, unless there is available cash, it also creates the need to sell another investment to finance that purchase. Therefore, it seems that one should look at multiple markets when considering how to allocate assets. 

Changes in CAPE show little dispersion 

Over the past 2 months, the CAPE for global equities has dropped from 22.6 to 17.7 a decline of 22%. Regional variations have been relatively small, with the UK and Europe having dropped the most by 24.4% and Asia ex Japan, where CAPE has fallen by only 18%.

Is Europe now the most attractive place to invest? Not really. Emerging Markets had the lowest CAPE ratio before the big market drop, and still remain the cheapest region. However, what if emerging markets are always the cheapest? In that case, an investor should not expect a big change in CAPE driven by a big change in price towards a long-term average.

Changes in CAPE 

Source:Research Affiliates, April 2020 

Comparisons should be across investments as well as across time 

Just like it is possible to compare any value against a long-term average, it is possible to compare current market valuations against their historical maximum and minimum values.   The below chart does just that for CAPE ratios of US, Japanese, UK, EAFE and Emerging equity markets as of March 2020. The current CAPE ratio for US equities is the only value that remains  in the top quartile. The rest of the world has current CAPE ratios, that are in the bottom quartile. In fact, stocks in Asia,, Japan and Emerging Markets each have a CAPE that even ranks in the bottom 5% of all their respective historical CAPE ratios.

If one believes that higher CAPE medium average should be applied for the US market (with lower interest rate) then one should apply the same logic for markets ex-US.  This would imply that the rest of the world markets are even cheaper than otherwise would be expected! 

Shiller P/E of selected markets (March 2020)

Source: This data is calculated by Research Affiliates LLC using data provided by MSCI Inc. and Bloomberg. The number shown on per region indicates the current P/E Shiller as per the date disclosed. The graph also indicates the Max Shiller P/E, the 75th percentile Shiller P/E, the Median Shiller P/E, the 25th percentile Shiller P/E, and the Minimum Shiller P/E per region, as illustrated for Japan’s region. 

No holy grail exists in investing

While the above comparison looks like convincing information to act upon and make money by selling US equities and re-investing in the rest of the world, unfortunately it is not as simple. Just because an indicator has proven useful to forecast equity markets in the past, does not mean the same will hold in the future. For example, we all might experience economic environments, that have no historical precedent. And CAPE itself has some critics, just like other valuation ratios.  The US market generally has a higher proportion of securities in the information technology sector when compared with other markets hence its higher CAPE versus others. Given the recent price moves in this sector this has given it a higher CAPE multiple.

The investment philosophy at MASECO leads us to be guided by the principles of both academic evidence as well as diversification at every level of investment thinking. So, while we view CAPE as one useful indicator, we would never “bet the house” on it. Instead, we budget a limited amount of risk to our regional equity allocation decisions. They are just one element in our approach to seek improved risk adjusted returns over the long term for our clientele. It is accompanied by other return drivers in both the asset allocation dimension (carry, trend, quality, etc) as well as the security selection (value, small cap, profitability, etc). While even these combinations  can fail to deliver the desired outcome, the odds of success are improved.

Despite the recent recovery rally, one should also not forget, that the Covid-19 pandemic is a “known unknown”: Even as visibility of both economic and market consequences has recently increased , there are still unknowns over how long the pandemic will last, how prolific it will be and how long the lockdown order(s) will be needed. 


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