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