What is the cape ratio and how can it help you in global markets?

As investors, we need to always make a judgement call on how expensive an asset is and whether it is worth buying it at the current price.  Whether it is stocks or bonds, they are cheap, priced right, or expensive.

Most investors would do well to focus on buying assets when they are cheap. Or put more positively, offer great value as oppose too expensive or overpriced.  In the case of investing in a diversified basket of global assets. This can be a very tricky task given the work required to really assess what is cheap or not.

One approach is to simply focus on buying a basket of cheaper global assets as part of your global asset allocation. For example, if Brazil, Russia, and Australia are currently at lower historical valuations the approach would be to invest in those countries as opposed to the more expensive ones.

To invest in global assets in this manner, the CAPE ratio can be very helpful as a method to identify a basket of cheaper countries to purchase.

What is the CAPE Ratio?

The CAPE ratio, or the cyclically adjusted price-to-earnings ratio, is a method using to determine the valuation of assets.  Other names for the CAPE ratio are the Shiller P/E, Shiller Ratio, or the P/E10.

CAPE was developed by Nobel Prize winner Dr. Robert Shiller and Dr. John Campbell as a way to use the ten year earnings ratio to determine when an asset may be cheap or expensive based on historical levels.  It is complicated to determine on your own. However there are some sites available that will provide it to you for various countries around the world.  More on that later.

How to Build a Portfolio of Cheap Global Investments

In his book “Global Asset Allocation”, Meb Faber outlined an easy to use method to buy a basket of global assets that has been proven to perform well over time.  This is not a short term get rich type of strategy, but rather a long-term process that has been show to beat the market over long periods of time.

The process works by buying a basket of index funds that each tracks one country based on their CAPE ratio.  For example, as part of a diversified portfolio, a U.S. investor could hold 50% of their portfolio in the S&P 500. Besides that, the rest spread out equally between ten of the cheapest countries in the world today.

The best site available to get the CAPE ratio for a country is Research Affiliates.  On this site they provide the expected future returns based on the current CAPE ratio.  If a CAPE ratio is lower than the median CAPE ratio over time. Then the country is expecting to have a higher return than another country that has a higher CAPE ratio.

An investor can simply go to Research Affiliates and sort the countries by expected return from high return to low return and buy the ten countries with the lowest CAPE ratio.  As of today, the ten cheapest countries are Russia, Poland, Italy, Spain, Turkey, Brazil, China, Malaysia, UK and Australia.

Easy to Say, Hard to Do

Investing with the CAPE ratio as part of a global strategy is hard to do.  The reason is that the strategy will often have you purchase countries at the height of peak pessimism.  For example, Turkey has a low CAPE indicating that it is a cheap country with higher than average expected returns.  However, Turkey has a low CAPE for a lot of good reasons – huge political tension, bombings, and a broken banking system.  It is hard to look at a country like Turkey right now and buy an index fund that tracks the performance of the Turkey stock market.

However, the research shows that over time ( it could be ten years or more), the returns provided by a country with a low CAPE will make up for this risk as low CAPE countries tend to eventually turn around and turn around in a big way.  This translates into market beating returns.

By buying a basket of at least ten of these low CAPE countries, you are using a well researched strategy to potentially beat the market and build up your portfolio.

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cape ratio is easy to say but really hard to do.
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