Advisors are well aware of the perils of chasing performance, especially when assets become clearly overvalued. New research, based on a variation of Robert Shiller’s CAPE ratio, shows that this is true at the country level.
Shiller’s 10-year cyclically adjusted for inflation price-to-earnings ratio (CAPE 10) has been used to forecast 10-year returns in the U.S. The mean forecast it provides has been found to be as accurate as any forecasting tool we have, with an r-squared of approximately 0.4 to realized returns. In his study, “Using CAPE to Forecast Country Returns for Designing an International Country Rotation Portfolio,” published in the July 2020 issue of The Journal of Portfolio Management, Sailesh Radha explored using CAPE to develop a forecast metric he called the “medium-term country yield forecast (CY-M).”
Radha amended the CAPE of a national equity market by combining it with the cyclically adjusted real exchange rate (RER 10, computed in the same manner as CAPE) of the country and the long-term, adjusted for inflation, price return momentum (MoM) of the market – the phenomenon of long-term price return momentum (with a look-back period of either 36 or 60 months) reversal documented in U.S. stocks by Jack Vogel and Wes Gray in their 2016 book, Quantitative Momentum. Radha noted that the rationale for using the real exchange rate is intuitive, as export-oriented economies depend on the relative price of exported goods and services in the international market.
Radha applied his CY-M derived from the adapted CAPE as a comparative measure to screen and rank countries in the MSCI All Countries World Index ex-U.S. ETF (ACWX) to construct an international country rotation equity portfolio. His data sample covered the ACWX for the period 1969-2016. By the end of the period, the number of countries in the index was 48.
Following is a summary of his findings:
- CAPE can be utilized as a medium-term yield forecast tool. The inverse CAPE has the highest correlation with forward returns across the nine-year time horizons with a median correlation of 0.75, followed by the eight-year horizons with a median correlation of 0.72.
- CAPE can be improved by amending the metric via the addition of the country’s RER 10 and a country’s trailing five-year momentum.
- With very few exceptions, RER 10 (correlation of about 0.4) and the trailing five-year MoM of national markets have significant influence over their forward returns – MoM experienced the highest correlation with forward returns over the eight-year time horizons with a median correlation of -0.48, followed by the nine-year time horizons with a median correlation of -0.47.
- When ranking countries in quintiles by CY-M over a 38-year period from January 1980 through December 2017, the spread in the alpha between the top and the bottom quintile was an average of 14.3% annually.
- With just 1.64% additional volatility relative to the index, the top quintile generated an alpha of 10.4%, whereas the bottom quintile generated a negative alpha of 3.9% with an additional 1.87% volatility. These are economically large figures given the relatively low costs of investing in country ETFs and the relatively low costs of trading them.
His findings led Radha to conclude:
With forward real returns experiencing the highest association with RER 10 and MoM (the measures used to potentially augment the forecasting potential of inverse CAPE) over eight-year time horizons and with inverse CAPE over nine-year time horizons, we can conclude that any forecasting model that comprises these three selected measures – picked with great intuition (as described in detail earlier) – can explain best the forward real returns over eight-year time horizons.
The takeaways for investors are that valuations matter and chasing the top performers without considering the likelihood of long-term momentum reversal is not likely to be a winning strategy.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Advisors are well aware of the perils of chasing performance, especially when assets become clearly overvalued. New research, based on a variation of Robert Shiller’s CAPE ratio, shows that this is true at the country level.
