Faber global value; how to spot bubbles, avoid market crashes, and earn big returns in the stock market (2014)

Data & CAPE Ratio UpdatesNearly all of the data used in this book are from Global Financial Data.. Trading in South Sea Company shares was one of the earliest “pump and dump” schemes in

Global Value

Table of Contents

Dedication

Data & CAPE Ratio Updates

Introduction – What Is A Bubble Anyway?

Chapter 1 - Bubbles Everywhere

Chapter 2 - You Are A Bad Investor

Chapter 3 - The CAPE Ratio

Chapter 4 - Valuation And Inflation

Chapter 5 - Criticisms Of The CAPE Ratio

Chapter 6 - Other Value Metrics

Chapter 7 - Does The CAPE Ratio Work Globally?

Chapter 8 - The Best Of Times, The Worst Of Times

Chapter 9 - A Global Stock Trading System

Chapter 10 - Why This Matters To You

be out of mind because I am out of sight? I am but waiting for you, for an interval, somewhere verynear just around the corner… All is well.”

-Written by Henry Scott Holland (1847 – 1918) Canon of St Paul’s Cathedral

Data & CAPE Ratio Updates

Nearly all of the data used in this book are from Global Financial Data Many of the concepts in thisbook were originally developed and refined by Benjamin Graham, David Dodd, Robert Shiller, andmany others too numerous to list

We update the global CAPE ratio values on our website, The Idea Farm, each quarter with archives:

www.theideafarm.com

The book’s homepage can be found at www.globalvaluebook.com

Introduction – What Is A Bubble Anyway?

What exactly is a bubble?

The Merriam-Webster dictionary definition of a bubble is “a state of booming economic activity thatoften ends in a sudden collapse.” Some people define a bubble as an extreme upward deviation from

a long-term price trend, while others declare a bubble when price decouples from an asset’sfundamental value In many cases, fundamental value is relative - how much worth a Van Goghpainting or a 1963 Corvette has to you may be very different from its worth to someone else For

example, Steve Cohen finds $10,000,000 worth of value in the sculpture The Physical Impossibility

of Death in the Mind of Someone Living, while another may simply see in the sculpture a dead and

rotting shark

Of course, financial assets are a little different than muscle cars and art in that they generate a stream

of cash flows through dividends or interest payments that act as an anchor to an estimate offundamental value Emotions, such as greed and fear can determine asset price movements in the shortterm, often causing prices to decouple from their fundamental values It is a sure sign that a bubbleexist in an asset class when a particular irrationality sets in and begins to govern our investingdecisions Think of the rush on tulips and futures in the 1600s that skyrocketed their prices to thevalue of a house, or when everyone wildly poured their money into Internet stocks in 1999, orfrantically flipped real estate in 2006 In many cases, debt and leverage are employed to magnify theeffects of the speculation

Yale economist and recent Nobel Prize award-winner Robert Shiller conveyed to NPR that a bubble

is “like a mental illness” and has the following characteristics:

• A time of rapidly increasing prices

• People tell each other stories that purport to justify the reasons for the bubble

• People tell each other stories about how much money they’re making

• People feel envy and regret that they didn’t participate

• The news media are involved

There is a lot of talk these days about bubbles, and while the US Treasury bubble talk has subsided abit, it may be replaced with the social media bubble, the farmland bubble, or perhaps the Bitcoinbubble More than likely, there is a bubble in talk of bubbles! People tend to vividly remember recent

painful events like losing a lot of money, and given the two large equity bear markets within the past

15 years in the US, investors may be overly sensitive to the recent past But, as Cliff Asness, Founder

of AQR Capital Management, clarifies in a recent Financial Analysts Journal article “My Top 10Peeves,” the term “bubble” has been diluted in the popular vernacular A “bubble” should technicallyrefer to a specific pattern of investment behavior, but instead has come to refer, more generally, toany perception of overvaluation Asness writes:

“To have content, the term bubble should indicate a price that no reasonable future outcome canjustify I believe that tech stocks in early 2000 fit this description I don’t think there wereassumptions – short of them owning the GDP of the Earth – that justified their valuations.However, in the wake of 1999-2000 and 2007-2008 and with the prevalence of the use of theword ‘bubble’ to describe these two instances, we have dumbed the word down and now use ittoo much An asset or a security is often declared to be in a bubble when it is more accurate todescribe it as ‘expensive’ or possessing a ‘lower than normal expected return.’ The descriptions

‘lower than normal expected return’ and ‘bubble’ are not the same thing.”

On the other extreme, there are those who believe that market bubbles don’t exist at all Or, if they doexist, proponents believe that you cannot reliably identify bubbles ahead of time in order to avoidtheir destruction to your portfolio Followers of the Efficient Market Hypothesis (EMH), such asEugene Fama, the American economist and fellow Nobel laureate, follow this philosophy Here,Fama offers his opinion from a 2010 interview with The New Yorker:

“I don’t even know what a bubble means These words have become popular I don’t think theyhave any meaning…It’s easy to say prices went down, it must have been a bubble, after the fact

I think most bubbles are twenty-twenty hindsight Now after the fact you always find people whosaid before the fact that prices are too high People are always saying that prices are too high.When they turn out to be right, we anoint them When they turn out to be wrong, we ignore them.They are typically right and wrong about half the time…They [bubbles] have to be predictablephenomena.”

So where does this leave us? Can we or can’t we predict when a bubble is occurring? Below wesearch for clues in one of the most famous bubbles of all time before trying to find an objective way

to identify bubbles, avoid their popping, and invest in their aftermath

Chapter 1 - Bubbles Everywhere

A fellow student of bubbles, Jeremy Grantham at Grantham, Mayo, Van Otterloo and Co (GMO) hascollected data on over 330 bubbles in his historical studies He points out in a recent research piece,

“Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever,” that one ofthe key difficulties is distinguishing when a bubble is indeed occurring, and when there actually is aparadigm shift In other words, when is this time really different?

Three of the most famous bubbles in history are the South Sea Company bubble of 1711–1720, the

Mississippi Company bubble of 1719–1720, and the Dutch tulip mania of the early seventeenthcentury, all of which saw drawdowns from peak to trough of 80-99% (Dreman, Contrarian Investment Strategies) We are not going to review these bubbles at length as many have done awonderful job already, and we have included a reading list at the end of this piece for furtherexploration While tulip mania and the Mississippi Company are both fascinating narratives, thisintroduction focuses on the South Sea Bubble of 1711-1720 since the term “bubble” was actuallycoined during this period

The South Sea Company was a British company founded by the high-ranking government official LordTreasurer Robert Harley England had amassed a large national debt during the War of SpanishSuccession, and the company was founded to help fund the government debt in a roundabout way,since the Bank of England had the only banking charter at the time The South Sea Company issuednew shares of stock to existing bondholders of the government debt In exchange for assuming thedebt, the government granted the company a monopoly on trade with South America while continuinginterest payments on the debt in the amount of 6% per year

In theory, this was a win-win scenario for all parties The company received cash flows to fundoperations (government bond payments), the government reduced their interest payments, and theholders of the government debt received shares in a company founded with a built-in monopoly andstaffed by high ranking government officials The South Sea Company continued to acquire more debtover the next few years with lower and lower interest payments

WHAT COULD POSSIBLY GO WRONG?

The investors in South Sea Company stock were convinced that the troves of wealth coming out of theSouth American gold mines would be traded for Europe’s fine textiles and other refined goods, all at

an obscene profit Unfortunately, profits from the shipping monopoly, which also included rights todeliver slaves to South America, never materialized, as only one ship was allowed transport peryear This reality did not stop a speculative frenzy from ensuing, as many secondary offerings ofSouth Sea stock were initiated with politicians receiving shares and options, thus incentivizing them

to further inflate the stock price further

As speculative trading in South Sea Company stock increased, other joint stock companies werelaunched on the London exchange Charles MacKay reviews some of the speculative companies beingfounded during this period in his book Extraordinary Popular Delusions and the Madness of Crowds, including one company that was founded with the purpose of “carrying on an undertaking ofgreat advantage, but nobody to know what it is.” In effect, none of the investors knew what thiscompany’s business model was The founder collected £2,000 for the share offering the next day andpromptly skipped town never to be heard from again (If this scenario seems implausible, recall therabid popularity of so-called special purpose acquisition corporations (SPACs) from 2005-2007 -essentially blank check companies that raised a hoard of capital based on a vague and imprecisebusiness plan Or perhaps consider many Internet and “app” companies today with high valuations,but no revenue model to speak of to back up such valuations.)

Another company planned to build floating offshore mansions for London’s elite, and yet another had

a formula to harness energy by reclaiming sunshine from vegetables These newly floated stockissuances were called “bubbles” at the time Eventually, the South Sea Company convinced members

of parliament (many of whom had already lined their pockets with South Sea Company shares) topass the Bubble Act on June 9, 1720, which prohibited the existence of any joint-stock company notauthorized by a royal charter South Sea Company had been granted a royal charter, and the BubbleAct, which passed before the peak of the run up of South Sea Company stock, helped foment thebubble by making South Sea Company shares all the more valuable

Trading in South Sea Company shares was one of the earliest “pump and dump” schemes in history.South Sea Company’s management lacked any relevant shipping and trading experience but wereshrewd stock promoters that took office space in the finest area of London’s financial district anddecorated their offices with opulent furniture and art The public could not get enough of the sharesgiven the ostensible wealth that had already been created for South Sea’s management group In theend, when the insiders knew that the company’s earnings would be abysmal, management beganquietly selling at the height of the market South Sea Company shares began to plummet, and to makematters worse, company officials allowed shareholders to borrow money to buy shares (effectivelygranting them margin) As share prices fell, investors were forced to sell even more shares

As seen in Figure 1, the stock price began the year 1719 at around £100, then raced to a peak ofnearly £1,000 before crashing all the way back down to £100 A number of high-ranking officialswere impeached or imprisoned and their estates were confiscated for their corruption Those officialsincluded the Chancellor of the Exchequer, the Postmaster General, and the heads of Ministry.Investors from all walks of life traded shares in the South Sea Company, from high-ranking officials,

to everyday craftsmen, to one very prominent scientist

FIGURE 1 – SOUTH SEA STOCK, 1718 - 1721

Source: Marc Faber, Gloom Boom and Doom, and “Riding the South Sea Bubble,” Temin and Voth.

“I can calculate the movement of the stars, but not the madness of men.”

The aforementioned quotation is attributed to Sir Isaac Newton, an unfortunate speculator in SouthSea Company during the period Marc Faber has compiled a chart of Newton’s trading ability in theprior figure, and it illustrates a few key points that have withstood the test of time: a) investmentbubbles have been around for centuries, and b) it is nearly impossible to stand aside while everyoneelse (your neighbor included) is getting rich Ironically enough, the company continued to operateuntil the 19th century, far outlasting all of the original shareholders

So, the real question is: Can you, as an investor, do anything to avoid Newton’s fate?

Chapter 2 - You Are A Bad Investor

Investors spend an inordinate amount of time and effort forecasting stock market direction, often withvery little success The conventional efficient market theory is that markets are not predictable andcannot be forecasted Most research demonstrates this to be true on aggregate The reality turns out to

be that investors are bad at investing

Because most of us tend to believe that we are exceptions to the rule, that we are somehow exemptfrom whatever general principle dictates the behavior of the masses, we often don’t realize that thosebehavioral laws include us, too For example, you probably think you are good at picking stocks (andinvesting in general) We hate to be the bearer of bad news, but you are not In fact, you are terrible atinvesting Now, there may be a few of you who outperform, and part of that is due to luck, but we arespeaking to the collective “you.”

The statistics back up this assertation DALBAR releases a yearly study called “The QuantitativeAnalysis of Investor Behavior” (QAIB) that compiles flow data of dollars into mutual funds It hasfound that the average investor underperforms the market by a significant amount

FIGURE 2 – INVESTOR RETURNS, 1993-2012

Source: Blackrock, DALBAR.

So why do most people think they are good investors? It is likely the same reason that most peoplethink they are better drivers, and certainly better looking than average It is a built-in behavioral bias

floating around in our genetics passed down from our ancestors many years ago (Readers of ourbooks excluded, of course!)

Don’t be too downtrodden; stock picking is hard - really, really hard The basic odds are stackedagainst you Longboard Asset Management completed a study called “The Capitalism Distribution”that examined stock returns from the top 3000 stocks from 1983-2007 They found the following:

• 39% of stocks were unprofitable investments

• 19% of stocks lost at least 75% of their value

• 64% of stocks underperformed the index

• 25% of stocks were responsible for all of the market’s gains

Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic indexfund and roughly a 40% chance of losing money

Not only is it hard to pick stocks, you are also up against the most talented investors in the world.There is a famous saying in poker, “If you sit down at the table and don’t know who the fish is –you’re the fish.” Most people who sit down at a poker table with a professional player will quicklylose all of their money While luck can have an influence in the short term, eventually the outcome isnear certain Most individual investors do not know that they are fish in the game known as WallStreet

And it’s not simply that most people are bad at investing It’s that we are often are own worstenemies when it comes to the market Why is this? One of the biggest reasons has to do with ouremotions Investors get upset when they are losing money and are euphoric when they are makingmoney This causes the repetitive behavior of selling at the bottom (“I can’t take it anymore”) andbuying at the tops (“look how much this went up, look how much money I’m making! I’m brilliant!”).The challenge with emotions is that they are not easily measured, and often surveys and otherbarometers of sentiment are available only for a few main markets Others, like the MagazineIndicator, are anecdotal at best Below is a good demonstration, however, of how bad people are atcontrolling their emotions

The American Association of Individual Investors (AAII) has been tracking a survey of investorssince 1987 Below on the chart you can see how investors have been positioned in three main

markets: stocks, bonds, and cash You can see where the peaks and valleys of sentiment occurred,which happened to be at or near market peaks One of the worst times to buy US stocks was January

2000 When did investors allocate most of their assets to stocks? January 2000 Investors should havebeen buying stocks hand over fist in March 2009, which is the absolute lowest allocation they hadsince 1987 Investors were most bearish at the exact bottom of the market

FIGURE 3 – AAII SURVEYS, 1987 – 2013

Source: AAII.

Source: AAII.

The point is, in bubbles and crashes, extremes in valuation are also accompanied by extremes insentiment Investors were most bullish when stocks were most overvalued at their peak and mostbearish at market bottoms If emotions often steer us in the wrong direction, it makes sense to ask: Isthere a way to remove our emotions from the equation? In the next chapter we take a look at anobjective measure to pick -when it is a good time to invest, and when it is a good time to step aside

Chapter 3 - The CAPE Ratio

Can having an objective approach to investing allow investors to remove their emotions from theprocess? Implementing an investment plan lets you break this emotional link and take advantage of theweakness of other investors Buy-and-hold investing is one successful way to approach the evils ofemotional investing But buy-and-hold investing still exposes investors to bubbles – they just have tosit through them, which can be really hard to do (According to Research Affiliates, there was a 68-year period in the US where stocks underperformed bonds That’s a long time to wait.)

Value has no place in the efficient market ivory tower, but does it seem reasonable for an investor, orperhaps a retiree, to have allocated the same amount of a portfolio to US stocks in December 1999versus in 1982 or 2009?

Perhaps it’s best to think of valuation as a strategic guide, rather than as a short-term timing tool It ismost 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 spiritscontained in the marketplace invariably cause prices to deviate quite substantially from ‘reasonable’levels The famous John Maynard Keynes phrase, “markets can stay irrational longer than you canstay solvent,” is appropriate here

There are numerous models to consider when valuing stock markets We are not going to summarizeall 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 andfair value estimates We direct the readers to the Appendix for some discussion of these alternativemodels, as well as to our blog, Meb Faber Research, and book website www.globalvaluebook.com

where we list links to other papers and resources mentioned in this book

A SIMPLE MODEL – THE CYCLICALLY ADJUSTED PRICE-TO-EARNINGS (CAPE)

RATIO

Benjamin Graham and David Dodd are widely seen as the fathers of valuation and security analysis

In their 1934 book Security Analysis, they were early pioneers in comparing stock prices withearnings smoothed across multiple years (their preference was five to ten years) Using backward-looking earnings allows the investor to smooth out the business and economic cycle, as well as pricefluctuations This long-term perspective dampens the effects of expansions as well as recessions

Robert Shiller, the author and Yale professor (and recent Nobel Laureate), popularized Graham andDodd’s methods with his version of this cyclically adjusted price-to-earnings (CAPE) ratio His

1998 paper, “Valuation Ratios and the Long-Run Stock Market Outlook,” was shortly followed by hisbook Irrational Exuberance, that included a warning on overvaluation of stocks prior to the 2000stock market bear market

Shiller maintains a website with an Excel download that includes historical data with formulasillustrating how to construct his 10-year CAPE ratio For a step-by-step guide Wes Gray at TurnkeyAnalyst has a good post that walks through the steps necessary to construct the metric

Figure 4 below is a chart of the CAPE ratio going back to 1881 The long-term series spends abouthalf of the time with values ranging between 10 and 20, with an average value of 16.5 The all-timelow reading was 4.8, reached at the end of 1920, and the high value of 44.2 was reached at, youguessed it, the end of 1999

FIGURE 4 - US 10-YEAR CAPE RATIO, 1880 -2013

Source: Shiller.

Asset allocators that believe in efficient markets allocate the same percentage of assets to equitieswhen valuations are high as they do when valuations are low But does that seem even remotelyreasonable looking at the above chart?

BUY LOW, SELL HIGH

In Figures 5 and 6, we examine a figure of all of the CAPE ratio readings from 1881 – 2011 Wepresent the real ten-year forward returns (real returns are returns an investor experiences afterinflation) The red bar in Figure 5 is where we find ourselves as of the end of 2013 - at a value ofapproximately 25

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 arehigher when valuations are low

FIGURE 5 - US STOCKS REAL RETURNS VS 10-YEAR CAPE RATIO, 1881 – 2011

Source: Shiller Total return series is provided by Global Financial Data and results pre-1971 are constructed by GFD Data from 1901-1971 uses the Standard and Poor’s Composite Price Index and dividend yields supplied by the Cowles Commission and from S&P 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.

We include a scatterplot to show that while the trend of value and future returns is clear, it onlyexplains a portion of future stock returns

FIGURE 6 - US STOCKS REAL COMPOUND RETURNS VS 10-YEAR CAPE RATIO, 1881 – 2011

Source: Shiller, GFD 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.

Chapter 4 - Valuation And Inflation

Besides general sentiment, what might cause this large variation in what multiples investors arewilling to pay for stocks? After all, at a current value of around 1848 as of this writing, the S&Pcould trade at either 370 or 3320 based on historical low and high multiples of 5 and 45,respectively It is difficult for most investors to comprehend the possibility of stocks declining orrising that much, but both of these multiples have occurred in the past Can you remember back to howdepressed you may have been in 2008 or 2002? Or perhaps how elated you were in 1999?

One of the factors that determines the valuation multiple investors are willing to pay is the inflationrate, as seen in Figure 7 The red bar is where we find ourselves at the end of 2013 with very mildinflation of 1.5%

When inflation is in the 1-4% “comfort zone,” investors are willing to pay a valuation premiumcompared to when there is high inflation or outright deflation Rob Arnott of Research Affiliatestouches on this important topic in his white paper, “King of the Mountain.” Two other books thattouch on CAPE ratios and inflation levels are Unexpected Returns by Ed Easterling and Bull’s Eye Investing by John Mauldin

FIGURE 7: SHILLER CAPE RATIOS VS INFLATION LEVELS, 1881 – 2011

Source: Shiller, Arnott 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.

THE 10 BEST, AND WORST, TIMES IN HISTORY TO INVEST

To illustrate the point of valuation extremes, we examined all year-end periods with a holding periodfor the next ten years What have been the ten best, and worst, years to invest since 1881? Figure 8details these years and their corresponding ten-year compounded real returns

FIGURE 8: 10 BEST, AND WORST, STARTING POINTS TO INVEST, 1881-2011

Source: GFD, Shiller.

Many of the best starting points seem obvious in retrospect The late 1940s were great entries thatpreceded the Nifty Fifty mania, and the Roaring Twenties are on the list The late 1980s certainlywould not be left out with the Internet bull market to follow

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 8 above is the valuations at the start of these 10-year periods Theaverage valuation for the 10 best years was 10.92 The average valuation for the ten worst years was23.31, more than double that of the best starting points With a value of around 25 at the end of 2013,the US stock market appears closer to a secular bear market starting point than a secular bull marketone

It seems fairly obvious that the best starting points are relatively cheap, and the worst starting pointsare more expensive Another way to visualize this property is from an excellent white paper fromJames Montier at GMO – “The 13th Labour of Hercules: Capital Preservation in the Age of FinancialRepression.”

It touches on a number of topics (namely negative real rates) but most interesting was the chart offorecasted returns relative to maximum drawdown in the next three years It should come as nosurprise, but when markets are expensive you have a greater chance of a large decline in comingyears Note – We last updated this chart in 2012, and due to CAPE multiple expansion the red linehas moved even more into dangerous territory

FIGURE 9: THREE-YEAR MAXIMUM DRAWDOWNS VS STARTING CAPE RATIO LEVEL, 1881-2011

Source: Shiller.

Chapter 5 - Criticisms Of The CAPE Ratio

An investor needs to be aware of the benefits, as well as the drawbacks, of using any investmentmodel Too many people follow their models and opinions with religious-like zeal, much to thedetriment of their portfolios Below we examine a few of the detractions commonly heard whendiscussing the CAPE ratio

The CAPE ratio measurement period is too long Critics claim recessions and expansions have an

outsized impact on the CAPE ratio long after the events have faded from memory “Estimating FutureStock Market Returns” by Adam Butler and Mike Philbrick tackles the issue of different measurementperiods from one year up to thirty (as well as other valuation models) and finds that most of themeasurement periods work pretty well too – a property called “parameter stability.” We take up thistopic later in this book and show the ideal period historically centers around seven years (thanks, BenGraham)

It is impossible to compare CAPE ratios across decades due to changes in accounting Much like

in our Shareholder Yield book, it is important to understand when there is a structural change in amarket, and when this time, it’s really different Critics complain about write-downs and how theycan bias the CAPE ratio Critics also claim adjustments to CPI, and accounting rules rendercomparisons across decades, or even centuries, inaccurate at best, and at worst, totally meaningless

We will examine some ways to think about the above criticisms to see if they impact the measure, and

if so, by how much Shiller uses Generally Accepted Accounting Principles (GAAP) earnings fromS&P, also known as reported earnings However, the early 2000s witnessed the introductions of FAS142/144 (and FAS 115 in 1993), which altered how companies amortize goodwill This change hasthe potential effect of biasing earnings down and the CAPE ratio up Liz Ann Sonders at Schwab

makes a few comments on the topic:

“More recently, the move toward fair-value accounting standards resulted in security losseshaving a devastating effect on the reported earnings of financial institutions during the recentfinancial crisis Yet that effect now appears to have been transitory If an accounting item isdeemed non-recurring, it’s common practice to ignore it when determining underlying earnings(i.e., using ‘operating’ instead of reported earnings) But CAPE continues to reflect the effect ofnon-recurring items for the 10 years that follow their initial recognition in reported earnings.”

Another CAPE ratio critic (but also Shiller’s best friend), Jeremy Siegel, penned this note in the FTback in August 2013 in “Don’t put faith in CAPE crusaders”:

“I believe the CAPE’s overly pessimistic predictions are based on biased earnings data.Changes in the accounting standards in the 1990s forced companies to charge large write-offswhen assets they hold fall in price, but when assets rise in price they do not boost earningsunless the asset is sold This change in earnings patterns is evident when comparing the cyclicalbehavior of Standard and Poor’s earnings series with the after-tax profit series published in theNational Income and Product Accounts (NIPA).”

Siegel published a longer white paper titled “The Shiller CAPE Ratio: A New Look.” He examines anumber of potential issues with the CAPE ratio, including the write-downs and what he calls “theaggregation bias.” Below we attempted to recreate Siegel’s work, and found mainly that the effect is

to move the entire ratio curve down Since 1940, the median value for the Siegel NIPA CAPE ratiowas 14 (vs 17 average) and the Shiller CAPE ratio was 17 (vs 25 average) Despite the difference

in absolute values, both ratios reach the same overarching conclusion generally and currently, albeitwith a different magnitude Stocks currently are not cheap

FIGURE 10: EARNINGS COMPARISONS, 1954-2013

Source: GFD, Bloomberg, Siegel, Shiller, McCauley.

Which series is “correct”? They both are, but perhaps the blue line is more consistent A betterquestion is, does it really matter?

A similar take on the topic is from Societe Generale who put out an excellent piece titled “To IgnoreCAPE is to Deny Mean Reversion.” They use the MSCI earnings index that doesn’t include the write-downs and they come to the same conclusions as using the S&P series – some current overvaluation

While we agree there may be some differences in the reported and operating series, later we examinethe CAPE ratio in over forty foreign markets with supporting results

Deep recessions bias the CAPE ratio too high Bubbly expansions bias the CAPE ratio too low.

Investors often find a way to justify their market position Here is a sample: “We don’t like using theCAPE ratio because it includes 2008-2009 earnings which distorts the CAPE ratio since earnings aretoo low.” The exact same argument could be used to ignore 2006-2007 as abnormally high However,

in either case if you make the adjustments, does it change the conclusion? This is a similar, butslightly different argument (one off recessions) than the prior one (an accounting inconsistency due towrite-downs)

To test the impact, we adjusted the earnings series so that earnings didn’t decline in 2008 and 2009(they had already started to decline a bit in 2007) The second chart is the adjusted CAPE ratioseries If you adjust the data, it moves the CAPE ratio from approximately 25 to 23 There isbasically no difference, and stocks are still expensive, but not terribly so due to the mild inflationsweet spot we are in This is one of the big benefits of smoothing earnings over a long period – anyshort term oscillation will not have an outsided impact

FIGURE 11: ORIGINAL AND ADJUSTED EARNINGS, 2000-2013

The CAPE ratio is not a short-term timing measure for one market Like most valuation measures, it is

a blunt tool, and should not be used to determine where to invest for the next few months It makesmuch more sense to align the indicator with the measurement period, and in this case we are looking

at 10 years However, nearly every value measure we track aligns to say the same thing – US stocksare currently expensive We will briefly examine a few alternative valuation metrics before turningour attention to global markets

Chapter 6 - Other Value Metrics

Residents of Los Angeles often wake up in the morning to a big grey haze out over the coast thatlocals affectionately refer to as the “marine layer.” Usually it “burns off,” sometimes by 10 am,sometimes 2pm, sometimes not at all

What does the Los Angeles “marine layer” have to do with stock market valuations? Like the hazeover the coast that we’re always waiting to “burn off,” high valuations take time to normalize Dr.Hussman suggests as much in his weekly commentary and in his chart below He shows that it doesn’treally matter which market valuation metric you prefer, most signal a bit of overvaluation to themarket While not every overvaluation is as catastrophically high as the late 1990s, it does mean thatuntil this valuation “burns off,” which can take a month or two after a crash, years, or even decades,

we can often expect somewhat muted returns of perhaps 2-4% nominal, or 0-2% real per year Beloware his charts that examine some basic valuation metrics (note how they move in unison)

FIGURE 13: VALUATION METRICS, SUBSEQUENT RETURNS, 1947 – 2013

Source: Hussman Funds.

What About Profit Margins?

One of the biggest variables in the earnings of companies is their profit margins, and if they are, orare not, sustainable Note how profit margins tend to oscillate in the below chart from the sameHussman piece It seems reasonable to believe that profit margins have the potential to mean revert,and to be cautious in estimating future returns with a more conservative profit margin value than toexpect that margins will stay elevated or even increase

FIGURE 14: PROFIT MARGINS, 1947-2013

Source: Hussman Funds.

Andrew Lapthorne at Societe Generale weighs in on the topic in a recent research piece:

“At the peak of the cycle, when profits are far above average and the economy is doing well, it

is hard to imagine earnings collapsing back below the average, as it is to imagine a depressedregion recovering Mean-reversion in earnings, though sometimes delayed, is as undeniable asthe economic cycle itself Cyclically adjusted (or trend) PE calculations will always give aconservative valuation estimate But that is exactly the point of valuation – to offer a degree ofsafety (a margin of error) and to smooth the dangers of the economic cycle That peak profitstypically accompany peak valuations only reinforces the point.”

One can always discuss the idiosyncrasies of any particular valuation metric, although we reachsimilar conclusions to Robert Shiller’s CAPE ratio analysis – but using a more modern time

frame and a different (and more generous) earnings series Our conclusions are that the USequity market is currently expensive We can also reach a similar conclusion using alternativevaluation metrics such as dividend yield, trend PE, and Tobin’s Q.

Most significantly, the downside risk of investing when earnings and valuations are far abovehistorical averages should not be underestimated From our work, peak earnings go hand-in-handwith peak valuations When earnings revert back to mean (and below), the valuation will alsocollapse That many continue to argue against this, and so soon after the collapse of 2008/09, issomething we find quite remarkable.”

FIGURE 15: US AND EUROPEAN PROFIT MARGINS, 1980-2013

Source: Societe Generale.

Indeed, James Montier at GMO finds himself on the other end of the discussion as Siegel – he

proposes that due to unsustainably high margins, the CAPE value is actually understated You can

read more in his recent piece “A CAPE Crusader.”

The CAPE ratio and other valuation methods are interesting on a stand-alone basis – but in this global

age, why focus on only one country? As the U.S CAPE ratio has approached expensive and,therefore, dangerous territory, investors should shift their focus to the global stock market The CAPEfor the U.S stock market has received a remarkable amount of attention in the past two years, but theU.S represents less than half the value of the global stock market It is important to expand theopportunity set to include all of the countries in the world to determine whether it is possible toseparate the currently cheap from the expensive.

While the U.S CAPE ratio signals caution, similar CAPE ratios for country stock markets around theworld signal opportunity Using the CAPE ratio to identify the most attractive countries and regionsaround the world can lead to impressive results Let’s explore how a global, CAPE based valuestrategy outperforms a single country approach

Chapter 7 - Does The CAPE Ratio Work Globally?

There is very little in the literature regarding global CAPE ratios for international equity markets.One such resource is Russell Napier, who authored Anatomy of the Bear: Lessons From Wall Street’s Four Great Bottoms and who discusses global CAPEs in a video here We also found tworecently published papers by Joachim Klement – “Does the Shiller-PE Work in Emerging Markets?”and “Value Matters: Predictability of Stock Index Returns” by Angelini, Bormetti, Marmi, andNardini

We examined 44 countries with data from Global Financial Data and Morningstar, including as muchdata as we could find We realize there is some bias in this study (German PE data to 1685 or French

to 1724 doesn’t really exist), but we did the best with what we have We utilized dollar based returns(and found local real returns to be nearly identical in a separate study) We do not include 11 frontiermarkets in the study due to their size, although we present their data for reference later in this book

While only two countries had century-long data (US and UK), most have data that goes back to the1970s and 1980s We only included data from the common period of 1969 forward in the belowtable

FIGURE 16 - GLOBAL COUNTRIES INCLUDED IN STUDY AND 10-YEAR CAPE RATIO, FEBRUARY 2014

Source: Global Financial Data.

FIGURE 17 - GLOBAL COUNTRIES INCLUDED IN STUDY AND 10-YEAR CAPE RATIO

Source: Global Financial Data.

Another way to look at this chart is to look at average valuations across all countries in the database.Figure 18 below seems to do a good job in identifying secular bull and bear starting points The onlybias is that equal weighting will overweight smaller countries, so perhaps a market cap or GDPweighted benchmark would be more reflective of the global landscape However there is no rule thatsays you have to invest in the global market cap index, rather, you want to invest where you will havethe highest future returns

FIGURE 18 - GLOBAL COUNTRIES INCLUDED IN STUDY AND AVERAGE 10-YEAR CAPE RATIO, 1980 - 2013

Source: Global Financial Data.

We examined all the countries on a yearly basis since 1980, CAPE ratio levels, and future returns.The sample includes approximately 10 countries in 1980, 20 in 1990, 30 by 2000, and 44 by 2010.The results are in the table below and largely confirm the US data Buy low, sell high

FIGURE 19 - 10-YEAR CAPE RATIO LEVELS AND FUTURE AVERAGE REAL

COMPOUND RETURNS, 1980 – 2013

Source: Global Financial Data, Morningstar 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.

We found that most CAPE ratios averaged around 15-20, bottomed out around 7, and maxed outaround 45 A few countries’ stocks markets made the United States bubble in the late 1990’s lookpathetic in comparison, like Japan reaching a value of nearly 100 in 1989 The red values in the chartabove are where global markets stood at the end of 2013 Both foreign indexes have CAPE ratiosaround 15, with foreign developed at 16 and foreign emerging at 15