Faber Uses CAPE To Compare Global Markets, Addresses Critics

Faber Uses CAPE To Compare Global Markets, Addresses Critics

After an incredible rally in 2013, sentiment on US stocks is bullish, bordering on euphoric. Some analysts think investors should buy stocks now so as not to miss out on the rest of the recovery, while others worry that we are in a liquidity bubble driven by years of loose monetary policy.

In his latest book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market, Cambria Investment Management portfolio manager Mebane Faber explains how to cut through the noise by applying the CAPE ratio (cyclically adjusted price-to-earnings) to the US market. More importantly, Faber delves into the debate on the validity of CAPE ratios to today’s market.

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Addressing CAPE’s critics

Because the measure is backward looking (10 years is typical), fundamental markets shifts, changes to accounting standards, and new regulations could all cause old data to skew the current CAPE ratio, and you’ll often find analysts arguing that it is either too high or too low.

Global Value addresses the main criticisms – that 10 years is too long, markets shouldn’t be compared across decades, or that deep recessions like the one we are now recovering from make CAPE less useful – and shows that even when you alter the underlying method to take these objections into account the overall picture doesn’t change. CAPE has a high degree of parameter stability, meaning that small adjustments to the theory result in small differences in the final valuation.

CAPE around the world

In those first few chapters, Faber is covering ground that should be familiar to experienced value investors, but the book earns its title when he then extends CAPE in two important ways to transform it into a global investment strategy.

First he calculates CAPE ratios for equity markets around the world. This might seem like an obvious next step, but the lack of data makes this harder than it sounds. Only the US and UK have more than a century of trading data to work with, and some emerging and frontier markets have had only had equity markets for a couple decades.

Then he establishes a rough relationship between the size of a bubble after it has collapsed, and the length of time it takes for markets to recover. This analysis even suggests that Japan’s lost decades, instead of being caused by some specific policies or vague cultural traits, is actually in line with what you would expect after the largest stock bubble in history collapsed. Faber concludes that the US really is fairly expensive right now (though he doesn’t see evidence of a bubble), and gives some actionable ideas on where to look for better value.

Global Value pulls together ideas from many of today’s top investment strategists (James Montier, Andrew Lapthorne, Jeremy Siegel) and gives readers a paradigm for understanding the relative valuation of global markets. By pointing out the sources that have informed his own strategies, Faber gives readers both a clear direction for further research and a firm base on which to build.

Get the book here , Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market

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