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Financial Manager

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CQR ISSUE 5 | August 2012

GLOBAL VALUE: BUILDING TRADING MODELS WITH THE 10-YEAR CAPE

ABSTRACT
Over seventy years ago Benjamin Graham and David Dodd proposed valuing securities with earnings smoothed across multiple years. Robert Shiller popularized this method with his version of the cyclically adjusted price-to-earnings ratio (CAPE) in the late 1990s, and issued a timely warning of poor stock returns to follow in the coming years. We apply this valuation metric across more than thirty foreign markets and find it both practical and useful. Indeed, we witness even greater examples of bubbles and busts abroad than in the United States. We then create a trading system to build global stock portfolios based on valuation, and find significant outperformance by selecting markets based on relative and absolute valuation.
Mebane T. Faber

The Ivy Portfolio

2321 Rosecrans Avenue Suite 3225 El Segundo, CA 90245 Phone: 310.683.5500 Fax: 310.683.5505 info@cambriainvestments.com www.cambriainvestments.com

CQR ISSUE 5 | August 2012

INTRODUCTION – THE FUTILITY OF FORECASTING
Investors spend an inordinate amount of time and effort forecasting stock market direction, often with very little success. The conventional efficient market theory is that markets are not predictable and cannot be forecasted. Value has no place in the efficient market ivory tower, but does it seem reasonable for an investor, or perhaps a retiree, to have allocated the same amount of a portfolio to stocks in December 1999 versus in 1982? Of course not. However, valuation is best used as a strategic guide rather than as a short-term timing tool. It is most useful on a time scale of years and decades rather than weeks and months (or even days). While we can formulate a hypothesis for where the S&P 500 ‘should’ be trading, the animal spirits contained in the marketplace invariably cause prices to deviate quite substantially from ‘reasonable’ levels, often for years and even decades. There are numerous models to consider when valuing stock markets, and a great summary can be found in a publication by The Leuthold Group titled, “Stock Market Valuation: What Works and What Doesn’t?” The paper covers a number of models, including price-to-earnings (P/E) on trailing 12-month earnings per share (EPS), P/E on 5-year normalized EPS, return on equity (ROE) based normalized EPS, dividend yield, price-to-book, price-to-cash flow, and price-to-sales. In general they find that many of these metrics are decent at forecasting stock returns. Other models include the Q-Ratio, and market capitalization to GNP/GDP (Buffett’s favorite). Another great summary is set forth in the paper “Estimating Future Stock Market Returns” by Adam Butler and Mike Philbrick. We are not going to summarize all of the stock valuation models in existence, but rather focus on just one. Often, in individual stocks as well as in stock markets, many of the value metrics end up producing broadly similar statistics and fair value estimates. We direct the readers to the Appendix as well as our blog World Beta where we list links to other papers and resources mentioned in this paper if they wish to explore other models more in depth.

A SIMPLE MODEL – TEN YEAR NORMALIZED EARNINGS
Benjamin Graham and David Dodd are universally seen as the fathers of valuation and security analysis. In their 1934 book “Security Analysis” they were early pioneers in comparing stock prices with earnings smoothed across multiple years, preferably five to ten years. Using backward looking earnings allows the analyst to smooth out the business and economic cycle, as well as price fluctuations. This long-term perspective dampens the effects of expansions as well as recessions. Robert Shiller, the author and Yale professor, popularized Graham and Dodd’s methods with his version of this cyclically adjusted price-to-earnings ratio (CAPE). His 1998 paper “Valuation Ratios and the Long-Run Stock Market Outlook” was shortly followed by his book “Irrational Exuberance” that included a warning on overvaluation prior to the 2000 stock market crash.

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CQR ISSUE 5 | August 2012

Shiller maintains a website with an Excel download that includes historical data with formulas illustrating how to construct his ten year CAPE. For a step-by-step guide Wes Gray at Turnkey Analyst has a good post that walks through the steps necessary to construct the metric. One common criticism of the CAPE is that the measurement period of ten years is too long. Critics claim recessions and expansions have an outsized impact long after they have faded from memory. “Estimating Future Stock Market Returns” by Adam Butler and Mike Philbrick tackles the issue of different measurement periods from one year up to thirty (as well as other valuation models). Critics also claim adjustments to CPI and accounting rules render comparisons across decades, or even centuries meaningless. While we agree there may be some variation, later in the paper we examine the CAPE in over 30 foreign markets with supporting results. Figure 1 below is a chart of the CAPE going back to 1881. The long-term series spends about half of the time with values ranging between 10 and 20, with an average and median value of about 16. The all-time low reading was 5, reached at the end of 1920, and the high value of 45 was reached at, you guessed it, the end of 1999.

FIGURE 1 US 10-YEAR CAPE 1881 - 2011

Source: Shiller

Asset allocators that believe in efficient markets allocate the same percentage of assets to equities when valuations are high as they do when valuations are low. But does that seem even remotely reasonable looking at the above chart?
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CQR ISSUE 5 | August 2012

THE 10 BEST, AND WORST, TIMES IN HISTORY TO INVEST
To illustrate this point, we examined all year-end periods with a holding period for the next ten years. What have been the ten best, and worst, years to invest since 1871? Figure 2 details these years and their corresponding ten-year compounded real returns. Many of the best starting points seem obvious in retrospect. 1948 and 1949 were great entries, preceding the Nifty Fifty mania, and of course 1918-1920 and the upcoming Roaring Twenties are on the list. 1988 and 1989 certainly would not be left out with the Internet bull market ahead as well. The same hindsight applies for the bad years as they often fell at the end of these massive bull runs. Bear markets set the stage for future bull markets and vice versa. One simple take away from Figure 2 below is the valuations at the start of these ten-year periods. The average valuation for the ten best years was 10.92. The average valuation for the ten worst years was 23.31, double that of the best starting points.

FIGURE 2 US STOCK REAL RETURNS VS. 10-YEAR CAPE 1881 - 2011

Source: Shiller. Index returns are for illustrative purposes only. Indices are unmanaged and an investor cannot invest directly in an index. Past performance is no guarantee of future results.

BUY LOW, SELL HIGH In Figures 3a and 3b, we examine a table of all of the CAPE yearly readings at the end of the year from 1881 – 2011. We list how often they occur, as well as the real forward returns. The red bar in Figure 3b is where we find ourselves as of the summer of 2012.
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CQR ISSUE 5 | August 2012

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.

FIGURE 3A US STOCK AVERAGE REAL COMPOUND RETURNS VS. 10-YEAR CAPE 1881 - 2011
1 Year fwd 3 Year fwd 5 Year fwd 7 Year fwd Rea l CAGR Rea l CAGR Rea l CAGR Rea l CAGR % occurrence 0.8% 25.4% 18.9% 21.6% 22.6% 17.1% 14.5% 12.6% 12.6% 11.6% 26.4% 31.0% 15.5% 5.4% 3.1% 0.8% 10.6% 6.4% 1.6% 1.3% 1.9% -12.5% 8.3% 4.7% 5.4% -1.0% 0.3% -17.0% 6.7% 5.2% 4.9% -1.3% -1.1% -4.8% 6.5% 5.3% 4.3% 1.5% -0.5% -1.5% 10 Year fwd Real CAGR 15.8% 10.5% 8.1% 5.2% 2.7% 3.3% -0.3% -3.5%

CAPE…...

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