CAPE crusaders: what’s too hot…and what’s not?

(With Stephen Moriarty)

CAPE ratio & expected returns

We’ve spoken at some length previously about the CAPE ratio, what it measures, and why it’s important.

As noted, the US CAPE ratio is presently high in historic terms, levitating at around 30, despite the troubling outlook for the US economy.

This points to only modest expected returns for the decade ahead, even before accounting for the downside risk for earnings, and inflation.

Such a historically high CAPE ratio has always ultimately been followed by a sharp decline in stock valuations too.

We spend so much time considering the US because it is the largest and most influential equities market in global terms.

And, as we have shown, given the interconnected nature of markets these days, if the US comes down then it will most likely bring other markets around the world down with it.

US exuberance

The US market has been more expensive than has been the case lately, as measured by CAPE, but only during the dotcom boom of the late 1990s through to 2000.

The market then crashed, which tells you much of what you need to know.

There may not be much sustainable upside from here, but potentially there’s a good deal of downside.

The so-termed ‘FANGMAN’ stocks have topped a valuation of US$7.1 trillion this week, an outlandish increase of nearly two-thirds since March, in spite of the obvious economic malaise.

US$7 trillion is apparently roughly equal to the combined GDP of Germany, Italy, and Indonesia, for whatever that’s worth!

Amazon, Google, Walmart and many of the highest-profile tech stocks ballooned to record highs this week.

Yet more than a fifth of America’s small businesses have been forced into closure this year due to the Coronavirus and recession.

Around the traps

Not every market around the world is nearly so expensive as the US, of course.

Britain has faced plenty of well-documented challenges across the past decade, and of the developed markets the UK’s FTSE index is reasonably attractively priced, with a CAPE ratio running at around 15.

Australia appears to be neither particularly cheap nor expensive at today’s levels.

A fair number of the emerging markets countries have been battered in recent times, and as such are cheaper still by comparison.

A flavour of emerging markets ‘value’ is represented by Turkey in our colour-coded chart below, but you might just as easily look variously at Russia or Korea, Spain or Poland, Chile or Pakistan, all of which have become cheap.

Emerging markets can be more volatile, of course, but this is a risk that can be managed using sensible asset allocation.

Alternatively, these days you can easily find ETFs or other ways to effectively cover a basket of emerging markets stocks.

Of the sectors, Energy was demonstrating reasonably attractive value this year, while some other sectors such as IT look to be very expensive.

Overall, there are still plenty of places you can find ‘value’ at the moment.

But our view is still that we need to be careful overall, given the heightened risk of a US correction.

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Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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