Is the CAPE 10 Useful in Forecasting Country Returns?
Advisors are well aware of the perils of chasing performance, especially when assets become clearly overvalued. New research, based on a variation of Robert Shiller’s CAPE ratio, shows that this is true at the country level.
Shiller’s 10-year cyclically adjusted for inflation price-to-earnings ratio (CAPE 10) has been used to forecast 10-year returns in the U.S. The mean forecast it provides has been found to be as accurate as any forecasting tool we have, with an r-squared of approximately 0.4 to realized returns. In his study, “Using CAPE to Forecast Country Returns for Designing an International Country Rotation Portfolio,” published in the July 2020 issue of The Journal of Portfolio Management, Sailesh Radha explored using CAPE to develop a forecast metric he called the “medium-term country yield forecast (CY-M).”
Radha amended the CAPE of a national equity market by combining it with the cyclically adjusted real exchange rate (RER 10, computed in the same manner as CAPE) of the country and the long-term, adjusted for inflation, price return momentum (MoM) of the market – the phenomenon of long-term price return momentum (with a look-back period of either 36 or 60 months) reversal documented in U.S. stocks by Jack Vogel and Wes Gray in their 2016 book, Quantitative Momentum. Radha noted that the rationale for using the real exchange rate is intuitive, as export-oriented economies depend on the relative price of exported goods and services in the international market.
Radha applied his CY-M derived from the adapted CAPE as a comparative measure to screen and rank countries in the MSCI All Countries World Index ex-U.S. ETF (ACWX) to construct an international country rotation equity portfolio. His data sample covered the ACWX for the period 1969-2016. By the end of the period, the number of countries in the index was 48.