Value Factor - CAPE Effect within Countries

Fundamental reason

Simple trading strategy

Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)

Source paper

Faber: 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 this 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 over thirty foreign markets and find it both practical and useful, and indeed 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.

Other papers

• Klement: Does the Shiller-PE Work in Emerging Markets?

  Abstract: We test the reliability of the Cyclically Adjusted PE (CAPE) or Shiller PE as a forecasting and valuation tool for 35 countries including emerging markets. We find that the Shiller-PE is a reliable long-term valuation indicator for developed and emerging markets and we use the indicator to predict real returns on local equity markets over the next five to ten years.

• Angelini, Bormetti, Marmi, Nardini: Value Matters: Predictability of Stock Index Returns

  Abstract: The aim of this paper is twofold: to provide a theoretical framework and to give further empirical support to Shiller's test of the appropriateness of prices in the stock market based on the Cyclically Adjusted Price Earnings (CAPE) ratio. We devote the first part of the paper to the empirical analysis and we show that the CAPE is a powerful predictor of future long run performances of the market not only for the U.S. but also for countries such us Belgium, France, Germany, Japan, the Netherlands, Norway, Sweden and Switzerland. We show four relevant empirical facts: i) the striking ability of the logarithmic averaged earning over price ratio to predict returns of the index, with an R squared which increases with the time horizon, ii) how this evidence increases switching from returns to gross returns, iii) moving over different time horizons, the regression coefficients are constant in a statistically robust way, and iv) the poorness of the prediction when the precursor is adjusted with long term interest rate. In the second part we provide a theoretical justification of the empirical observations. Indeed we propose a simple model of the price dynamics in which the return growth depends on three components: a) a momentum component, naturally justified in terms of agents' belief that expected returns are higher in bullish markets than in bearish ones; b) a fundamental component proportional to the log earnings over price ratio at time zero. The initial value of the ratio determines the reference growth level, from which the actual stock price may deviate as an effect of random external disturbances, and c) a driving component ensuring the diffusive behaviour of stock prices. Under these assumptions, we are able to prove that, if we consider a sufficiently large number of periods, the expected rate of return and the expected gross return are linear in the initial time value of the log earnings over price ratio, and their variance goes to zero with rate of convergence equal to minus one. Ultimately this means that, in our model, the stock prices dynamics may generate bubbles and crashes in the short and medium run, whereas for future long-term returns the valuation ratio remains a good predictor.

• Ellahie, Katz, Richardson: Risky Value

  Abstract: Countries with higher levels of B/P have higher levels of subsequent earnings growth and exhibit much greater variability in that future earnings growth. Consistent with a risk based explanation for B/P predicting country level returns, we find strong evidence that the sensitivity of subsequent earnings growth to contemporaneous global earnings growth (and global market returns) is greater on the downside for countries with higher levels of B/P. Furthermore, B/P is relatively more important than E/P in explaining country level returns for countries with higher and more uncertain expectations of future earnings growth. Controlling for ex post realizations of earnings growth subsumes the ability of B/P to explain country returns. Overall, the results suggest that expectations of risky earnings growth, as reflected in B/P, play a significant role in explaining country returns.

• Zaremba: Country Selection Strategies Based on Value, Size and Momentum

  Abstract: This study provides convincing evidence that stock markets with low capitalisation, low valuation ratios and good past performance ten to outperform country markets with high capitalisation, high valuation ratios and low momentum. Based on sorting procedures and cross-sectional tests conducted across 78 countries over the period 1999 to 2014, it has been found out that value, size and momentum effects at the country level are stronger across small and medium country markets than large ones. Thus, bearing in mind the declining benefits of international diversification observed in recent decades, it is recommended that investors include country-level factor premiums in their strategic asset allocation, without postponing them to further stages of an investment process. In addition, it has been shown that intermarket value, size and momentum effects may be used in multifactor asset pricing models, which perfectly explains the variation in stock returns at the country level.

• Novotny, Gupta: The Dynamics of Value Across Global Equity Markets: The Risk Contagion

  Abstract: The ratio between the share price and current earnings per share, the PE ratio, is widely considered to be an effective gauge of under/overvaluation of a corporation’s stock. Arguably, a more reliable indicator, the Cyclically-Adjusted Price Earning ratio or CAPE, can be obtained by replacing current earnings with a measure of permanent earnings i.e. the profits that a corporation is able to earn, on average, over the medium to long run. In this study, we aim to understand the cross-sectional aspects of the dynamics of the valuation metrics across global stock markets including both developed and emerging markets. We use a time varying DCC model to exploit the dynamics in correlations, by introducing the notion of value spread between CAPE and the respective Market Index from 2002 to 2014 for 34 countries. We find periods, notably around the 2008 financial crisis, when the value spread shows large degree of variation and thus provide a statistically significant signal for the asset allocation. The signal can be utilized for better asset allocation as it allows one to interpret the common movements in the stock market for under/overvaluation trends. These estimates clearly indicate periods of misvaluation in our sample. Furthermore, our simulations suggest that the model would have been able to provide early warning signs of misvaluation in real time on a global scale and formation of asset bubbles.

• Keimling: Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators?

  Abstract: Existing research indicates that it is possible to forecast potential long-term returns in the S&P 500 for periods of more than 10 years using the cyclically adjusted price-to-earnings ratio (CAPE). This paper concludes that this relationship has also existed internationally in 17 MSCI Country indexes since 1979. In addition, the paper also examines the forecasting ability of price-to-earnings, price-to-cash-flow and price-to-book ratio, as well as that of dividend yield and of CAPE adjusted for changes in payout ratios. The results indicate that only price-to-book ratio and CAPE enable reliable forecasts on subsequent returns and market risks. In countries with structural breaks, price-to-book ratio even exhibits some advantages compared to CAPE. Based on these findings, the long-term equity market potential for various markets is forecasted using CAPE and price-to-book ratio. The current valuation makes it likely that investors with a global portfolio can achieve real returns of 6% over the next 10 to 15 years. Even greater increases can be expected in European equity markets (8%) and in emerging markets (9%). Due to the high valuation of the US stock market, US investors can only expect below-average returns of 4% with a higher drawdown potential.

• Ilmanen, Israel, Moskowitz, Thapar, Wang: Factor Premia and Factor Timing: A Century of Evidence

  Abstract: We examine four prominent factor premia - value, momentum, carry, and defensive - over a century from six asset classes. First, we verify their existence with a mass of out-of-sample evidence across time and asset markets. We find a 30% drop in estimated premia out of sample, which we show is more likely due to overfitting than informed trading. Second, probing for potential underlying sources of the premia, we find little reliable relation to macroeconomic risks, liquidity, sentiment, or crash risks, despite adding five decades of global economic events. Finally, we find significant time-variation in factor premia that are mildly predictable when imposing theoretical restrictions on timing models. However, significant profitability eludes a host of timing strategies once proper data lags and transactions costs are accounted for. The results offer support for time-varying risk premia models with important implications for theory seeking to explain the sources of factor returns.

• Xie, Amy: Forecasting Long-Term Equity Returns: A Comparison of Popular Methodologies

  Abstract: Many investors need to make long-term asset class forecasts for planning and portfolio construction purposes. We examine the empirical performance of two different approaches to forecasting future ten-year equity returns: a regression methodology using CAPE and a more traditional “building block” approach. The regression approach produces estimates that are poor predictors of subsequent actual returns. The “building block” approach (BBA) outperforms the regression methodology (in terms of root mean squared error) with the repricing component helping to capture periods of poor equity returns. A high CAPE value is not necessarily cause for alarm and changes in asset allocation. If an investor plans to use a methodology that over time will prove more accurate, then the historical record is more supportive of the BBA approach, with or without a repricing component based on current P/E.

• Boucher, Jasinski, Tokpavi: Conditional Mean Reversion of Financial Ratios and the Predictability of Returns

  Abstract: While traditional predictive regressions for stock returns using financial ratios are empirically proven to be valuable at long-term horizons, evidence of predictability at few-month horizons is still weak. In this paper, based on the empirical regularity of a typical dynamic of stock returns following the occurrence of a mean reversion in the US Shiller CAPE ratio when the latter is high, we propose a new predictive regression model that exploits this stylized fact. In-sample regressions approximating the occurrence of mean reversion by the smoothed probability from a regime-switching model show superior predictive powers of the new specification at few-month horizons. These results also hold out-of-sample, exploiting the link between the term spread as business cycle variable and the occurrence of mean reversion in the US Shiller CAPE ratio. For instance, the out-of-sample R-squared of the new predictive regression model is ten (four) times bigger than that of the traditional predictive model at a 6 (12) month horizon. Our results are robust with respect to the choice of the valuation ratio (CAPE, excess CAPE or dividend yield), and countries (Canada, France, Germany and the UK). We also conduct a mean-variance asset allocation exercise which confirms the superiority of the new predictive regression in terms of utility gain.

• Rajan Raju: Shiller’s CAPE and Forward Excess Returns in India

  Abstract: We show an inverse relationship between elevated valuations (high CAPE) and forward excess returns over 1, 3, 5, and 10 years in India, similar to other international studies. At the end of June 2022, as measured by Shiller Barclays CAPE, valuation is at the 77th percentile of its historical distribution. There is a reasonable probability (40%) that 1-year forward returns are negative when CAPE is in its highest quintile. While “time in the market” reduces the chance of negative forward excess returns, these returns are still lower than entering at lower quintiles of CAPE. Longer-term, forward excess returns have significant variability. Therefore, CAPE on its own has limited use for market timing. However, the inverse relationship implies that investors should lower their forward excess return expectations and consider longer investment time horizons when starting CAPE is high without sound economic rationale.

• Chabi-Yo, Fousseni and Langlois, Hugues: Conditional Leverage and the Term Structure of Option-Implied Equity Risk Premia

  Abstract: In a one-period economy, Martin (2017) and Chabi-Yo and Loudis (2020) derive bounds for the equity risk premium that use options of the same maturity as the horizon at which the premium is measured. In contrast, we provide an expression and an empirical methodology to measure the premium at a given horizon in a multi-period economy using options of multiple maturities. The premium depends on risk-neutral leverage effects and the expected future risk-neutral market variance and skewness, which contribute to increasing the premium at short horizons. Our measure outperforms in terms of prediction accuracy and portfolio allocation performance. The term structure of expected excess holding period returns is flatter on average and dramatically more negative during market turmoil than those implied by previous measures.

• Hillenbrand, Sebastian and McCarthy, Odhrain: The Optimal Stock Valuation Ratio

  Abstract: Stock valuation ratios contain expectations of returns, yet, their performance in predicting returns has been rather dismal. This is because of an omitted variable problem: valuation ratios also contain expectations of cash flow growth. Time-variation in cash flow volatility and a structural shift towards repurchases have magnified this omitted variable problem. We show theoretically and empirically that scaling prices by forward measures of cash flows can overcome this problem yielding optimal return predictors. We construct a new measure of the forward price-to-earnings ratio for the S&P index based on earnings forecasts using machine learning techniques. The out-of-sample explanatory power for predicting one-year aggregate returns with our forward price-to-earnings ratio ranges from 7% to 11%, thereby beating all other predictors and helping to resolve the out-of-sample predictability debate (Goyal and Welch, 2008).

• Jacob, Joshy and Raju, Rajan: Forecast or Fallacy? Shiller's CAPE: Market and Style Factor Forward Returns in Indian Equities

  Abstract: This paper explores the relationship between CAPE and future returns across a range of market benchmarks and long-only styles in the Indian equity market. We create and use a new Shiller CAPE series for India using indices that are publicly available. We find a statistically significant inverse relationship between CAPE values and forward returns across styles and periods, although CAPE may not strictly qualify as a market timing tool. In addition, there is a direct relationship between CAPE and drawdowns. These findings suggest that investors should adapt their expectations of investment returns based on CAPE value. We show that different size-and style-based indices have different reaction functions to the same starting value of CAPE with value and low volatility showing higher resilience. The study contributes to the evidence from the Indian market on the predictive power of valuations for future returns, improving our understanding of market dynamics.

• Safari, Sara A. and Schmidhuber, Christof: Trends and Reversion in Financial Markets on Time Scales from Minutes to Decades

  Abstract: We empirically analyze the reversion of financial market trends with time horizons ranging from minutes to decades. The analysis covers equities, interest rates, currencies and commodities and combines 14 years of futures tick data, 30 years of daily futures prices, 330 years of monthly asset prices, and yearly financial data since medieval times.Across asset classes, we find that markets are in a trending regime on time scales that range from a few hours to a few years, while they are in a reversion regime on shorter and longer time scales. In the trending regime, weak trends tend to persist, which can be explained by herding behavior of investors. However, in this regime trends tend to revert before they become strong enough to be statistically significant, which can be interpreted as a return of asset prices to their intrinsic value. In the reversion regime, we find the opposite pattern: weak trends tend to revert, while those trends that become statistically significant tend to persist.Our results provide a set of empirical tests of theoretical models of financial markets. We interpret them in the light of a recently proposed lattice gas model, where the lattice represents the social network of traders, the gas molecules represent the shares of financial assets, and efficient markets correspond to the critical point. If this model is accurate, the lattice gas must be near this critical point on time scales from 1 hour to a few days, with a correlation time of a few years.