Value Factor – CAPE Effect within Countries

Investors have always tried to asses whether the equity market is cheap or dear. Various methodologies have been used for this purpose, but most of them try to compare the actual price of equities to an internal value derived from equity earnings or book values.

Numerous academic research papers show that equity valuation has predictive ability for future equity returns. However, its power is limited to very long holding periods (5-10 years) as noise and various behavioral effects cause prices to deviate quite substantially from ‘fair’ values, often for many years. A rotational trading strategy which periodically rotates to countries with the most undervalued equity markets helps to get around these problems.

Fundamental reason

The anomaly has its source in investor psychology. Academic research postulates that investors overreact to news and events; “winners”, i.e. favorite countries, tend to be overvalued while “losers”, i.e. neglected countries, are undervalued. The contrarian investor can, therefore, exploit this generic investor mentality to capitalize on the inefficiency of the market to reap financial gains when stock prices revert to their intrinsic values.

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Markets Traded

Financial instruments

Confidence in anomaly's validity

Backtest period from source paper

Notes to Confidence in Anomaly's Validity

Indicative Performance

Period of Rebalancing

Notes to Indicative Performance

per annum, real return (adjusted for inflation), data from figure 9 for equally weighted cheapest 33% of countries

Notes to Period of Rebalancing

Estimated Volatility

Number of Traded Instruments

Notes to Estimated Volatility

data from figure 9 for equally weighted cheapest 33% of countries

Notes to Number of Traded Instruments

Maximum Drawdown

Complexity Evaluation
Moderately complex strategy

Notes to Maximum drawdown

data from figure 9 for equally weighted cheapest 33% of countries

Notes to Complexity Evaluation

Sharpe Ratio

Simple trading strategy

The investment universe consists of 32 countries with easily accessible equity markets (via ETFs, for example). At the end of every year, the investor calculates Shiller’s “CAPE” Cyclically Adjusted PE) ratio, for each country in his investment universe. CAPE is the ratio of the real price of the equity market (adjusted for inflation) to the 10-year average of the country’s equity index (again adjusted for inflation). The whole methodology is explained well on Shiller’s home page ( or on The investor then invests in the cheapest 33% of countries from his sample if those countries have a CAPE below 15. The portfolio is equally weighted (the investor holds 0% cash instead of countries with a CAPE higher than 15) and rebalanced yearly.

Hedge for stocks during bear markets

No - ong-only value stocks/countries logically can’t be used as a hedge against market drops as a lot of strategy’s performance comes from equity market premium (as the investor holds equities, therefore, his correlation to the broad equity market is very very high). Now, evidence for using a long-short value factor portfolio as a hedge against the equity market is very mixed. Firstly, there are a lot of definitions of value factor (from a simple standard P/B ratios to various more complex definitions as in this strategy), and the performance of different value factors really differ in times of stress. But there are multiple research papers in a tone of work of Cakici and Tan : “Size, Value, and Momentum in Developed Country Equity Returns: Macroeconomic and Liquidity Exposures” that link value factor premium to liquidity and growth risk and shows that the implication is that value factor returns can be low prior to periods of low global economic growth and bad liquidity.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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