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Country CAPE Ratios (Part 2): Local Currency Returns

Summary In a previous article, we found that CAPE ratios did an excellent job of predicting country returns in 2013 but did a lousy job in 2014. Several commentators raised the point the analysis should have taken into account currency fluctuations. This article conducts the same analysis as before but uses local currency returns to evaluate the performance of CAPE in 2013 and 2014. Introduction The cyclically-adjusted price-to-earnings [CAPE] ratio is a commonly-used measure of valuation that has had some success in predicting long-term returns. In a chart from recent article by Hussman Funds entitled ” Does the CAPE still work? “, CAPE was found to be a reliable predictor (> 90% accuracy) of actual 10-year returns of S&P 500. The major deviations between the expected and actual 10-year returns occurred when the U.S. markets became very overvalued or very undervalued. In my previous article entitled ” Country CAPE Ratios: Wizard In 2013, Dunce In 2014? “, I mentioned the Cambria Global Value ETF (NYSEARCA: GVAL ), a fund launched in March 2014 by Mebane Faber and Cambria Investments that uses CAPE-like methodologies to invest in the cheapest markets worldwide. The timing of GVAL’s launch coincided nicely with CAPE’s fantastic performance at predicting 2013 country returns. In his “Meb Faber Research” blog , Faber presented data showing that the 5 cheapest and 10 cheapest countries posted average gains of 20.74% and 21.11%, respectively, while the 5 most-expensive and 10 most-expensive countries averaged -17.81% and -5.39%, respectively. This represents a differential of 38.59% for the 5 cheapest versus the 5 most-expensive, and 26.5% for the 10 cheapest versus the 10 most-expensive, a remarkable outperformance. Unfortunately, CAPE did a lousy job in 2014. The data showed a surprising positive correlation between CAPE and 2014 returns, meaning that the more expensive countries actually did better than the cheaper countries. I even ribbed on Faber for keeping quiet about CAPE’s performance throughout 2014, even though in 2013 Faber had enthusiastically proclaimed ” CAPE Country Returns YTD, the Ball Don’t Lie! ” a month before year-end. Perhaps Faber read my article, because he dutifully provided a CAPE update on New Year’s Day, 2015, even joking that the new edition of his book would be entitled “Global More Value.” Both Faber and my own performance data quoted USD returns. However, several astute commentators on my last article suggested that the true way to gauge CAPE should have been to use local currency returns. Therefore, this article seeks to evaluate local currency stock market performances to see if CAPE did any better in 2014 (or any worse in 2013). For the interest of consistency I will be using the same set of countries I did my previous article, even though Faber provided a more comprehensive list of country CAPE numbers in his update, which was posted after my article. 2013 Country CAPE evaluation The following table shows the 2013 return performances the various countries in both local currency [LC] and US dollar [USD] terms. Local currency returns were obtained from stock exchange performance data from the Wall Street Journal while USD returns are based on the ETFs and were obtained form Morningstar . Note that the country ETFs (often based on MSCI or FTSE indices) do not necessarily correspond to their respective stock exchanges. Country ETF CAPE at end-2012 2013LC % 2013USD % Greece GREK 2.6 28.06 24.91 Ireland EIRL 5 33.64 45.58 Argentina ARGT 5.2 88.87 15.04 Russia ERUS 7.2 -5.55 -0.88 Italy EWI 7.4 16.56 19.07 Austria EWO 8.4 4.24 11.48 Spain EWP 8.5 21.42 31.91 Portugal PGAL 9.5 15.60 – Belgium EWK 10.3 18.10 24.6 Israel EIS 11.1 15.12 18.3 Canada EWC 18.3 9.55 5.31 South Africa EZA 18.5 17.85 -7.47 India INDY 19.3 8.98 -3.99 Malaysia EWM 20.1 10.54 7.84 USA SPY 21.1 29.60 33.45 Chile ECH 21.2 -14.00 -23.9 Mexico EWW 21.2 -2.24 -1.58 Indonesia EIDO 24.7 -0.98 -23.14 Colombia GXG 33.5 -11.18 -15.01 Peru EPU 33.7 -23.63 -25.42 I compiled the total return performances into a bar chart. Countries are sorted from left to right, in order of increasing CAPE values. Local currency returns are shown as blue bars whereas USD returns are shown as orange bars. (click to enlarge) The data is also shown as a scatterplot, showing the relationship between CAPE at end-2012 and local currency returns in 2013. As with the 2013 USD returns, we see a negative relationship between CAPE at end-2012 and 2013 LC returns. The R-squared value of 0.3845 is less than the R-squared value for 2013 USD returns presented in the previous article, which was 0.5365. Nevertheless, the correlation was still significant (p-value = 0.0046). 2014 Country CAPE evaluation The following table shows CAPE values for selected countries at end-2013 and their 2014 LC and USD returns. Again, I am using the same countries as I did in my previous article. Country ETF CAPE at end-2013 2014LC % 2014USD % Greece GREK 3.8 -28.9 -38.2 Russia RSX 7.0 -12.1 -45.0 Ireland EIRL 7.3 15.1 1.9 Argentina ARGT 7.4 59.1 2.9 Jordan 8.6 Italy EWI 8.6 0.2 -9.9 Hungary 8.6 Austria EWO 9.0 -15.2 -20.1 Croatia 9.8 Lebanon 10.0 Israel ESI 10.3 10.5 0.7 Spain EWP 10.3 3.7 -4.7 Singapore EWS 11.8 6.2 2.9 Belgium EWK 12.3 12.4 1.8 Norway NORW 13.1 2.8 -22.8 Netherlands EWN 13.4 5.6 -4.7 United Kingdom EWU 13.6 -2.7 -5.9 France EWQ 14.0 -0.5 -9.9 Australia EWA 15.4 0.7 -3.8 Hong Kong EWH 16.3 1.3 4.6 Germany EWG 16.4 2.7 -10.5 Switzerland EWL 18.9 9.5 -0.8 Canada EWC 19.1 7.4 1.4 Japan EWJ 21.1 7.1 -4.4 USA SPY 25.4 11.4 11.4 And as a bar chart: (click to enlarge) We can see that for most of the countries, the 2014 local currency returns (blue bars) are higher than the 2014 USD returns (orange bar). This is likely due to the rising strength of the US dollar throughout 2014. The data are also presented as a scatterplot: As with the 2014 USD returns, we see a counter-intuitive positive relationship between CAPE values and 2014 local currency returns, but this time the correlation is much weaker (R-squared = 0.0192 compared to R-squared = 0.2664). Unlike 2014 USD returns, this correlation was not significant (p-value = 0.55). The difference between the 2014 USD and 2014 local currency results is probably due to currencies such as the Russian rouble and the Argentine peso, which fell off the cliff in 2014. Hence, local Argentine investors would have been ecstatic at their country’s 59.1% performance in 2014, whereas USD investors would be stuck with a measly 2.9% return. While this might seem like an endorsement for foreign currency hedging (particularly when it seems that every analyst and their brother is forecasting the U.S. dollar to continue to rise throughout 2015), keep in mind that predicting foreign currency movements is notoriously difficult, and that the expected value of excess returns on currencies in the long-term is basically zero. Faber himself says that it does not matter whether or not you hedge, as long as you do it fully one way or the other, as to not take a directional view on any one currency. Summary CAPE’s track record in 2014 does not look so bad once currency fluctuations are taken into account. Instead of predicting the opposite trend (more expensive countries did better on a USD basis in 2014), CAPE had no predictive power at all in 2014 for local currency returns. Nevertheless, it should be stressed that CAPE is a long-term measure of valuation, and deviations from the predicted trend should be expected as part of the natural volatility of the markets. In fact, true value investors should embrace these deviations as they might be able to buy the cheapest markets at an even cheaper price.

Gary Gordon Positions For 2015: Tactical Asset Allocations For ETF Investors

This is the third piece in Seeking Alpha’s Positioning for 2015 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction. Gary A. Gordon, MS, CFP® is the president of Pacific Park Financial, Inc. , a Registered Investment Adviser with the SEC. He has more than 24 years of experience as a personal coach in “money matters,” including risk assessment, small business development and portfolio management. Gary is often asked to consult as an educator. He has taught financial concepts in Mexico, Singapore, Hong Kong, Taiwan and the United States. As a Certified Financial Planner™ (CFP®), Gary has distinguished himself as a reputable and trusted investor advocate. He writes commentary for ETF Expert, Seeking Alpha and TheStreet. Gary’s participation on local and national radio has spanned more than a decade, and he currently hosts the ETF Expert Show. Seeking Alpha’s Carolyn Pairitz recently spoke with Gary to find out how he goes about selecting specific ETFs and plans to use them to position clients in 2015. Carolyn Pairitz (CP): How would your clients describe your investing style/philosophy? Gary Gordon (GG): My clients would recite my mantra… There are four possible investing outcomes (i.e., big gain, small gain, small loss, big loss) and three of them are good. Successful investing is about controlling the investing outcome so that you ensure a big gain, small gain or small loss, and take action to avoid the big loss. The humongous loss is the only thing that can destroy a lifetime of wealth-building. By way of example, I may own rental property in California where I live, perhaps for its capital appreciation potential as well as its annual cash flow. And along the way, I may experience price gains and dips, good renters and bad. But the one thing that my financial well-being would not be able to tolerate is an earthquake that decimates the property. It follows that, I may not enjoy paying the earthquake insurance premium each year, but I understand the criticality of doing so. The exact same insurance principles go for investing in market-based securities. Stop-limit loss orders, technical trendlines, put options, non-correlated assets, hedges – no technique or asset type will eliminate downside risk completely nor appear particularly worthwhile in extremely bullish uptrends. Yet the tactical asset allocation decision-making to insure against the only thing that can kill a portfolio – the big loss – keeps my clients on track to achieve their financial freedom goals. CP: Which global issue is most likely to adversely affect U.S. markets in 2015? GG: Ironically enough, I have the same answer for 2015 that I provided in 2014’s interview: Deflation. Europe and Japan are both still struggling to beat deflationary pressures back; their 2014 efforts to stimulate their respective economies with asset purchases and negligible/non-existent or even negative overnight lending rates have pummeled their currencies more than anything else. Indeed, the U.S. stock bull got knocked for a loop in October because of deflationary recession scares around the globe. So what did the U.S. Fed do? One of its committee members publically questioned whether or not the institution should even end QE3. Only then did U.S. large cap stocks rapidly recover from what might have been far worse than an intra-day 9.8% correction. For better or worse, our market continues to rely on central bank manipulation. The Fed will be exceedingly “patient” in 2015, and may even decide by late 2015 to talk about ways to be accommodative yet again. They may have no choice. Consider the fact that, while Russia’s direct impact on the U.S. economy is small, the country matters a whole lot to Europe’s well-being. And Europe is reeling even without Russian woes. In essence, if world markets determine that the European Central Bank (ECB) is not aggressive enough with its stimulus, a region-wide recession would certainly drag on U.S. equities. CP: Have any ETFs that have launched this year caught your eye? GG: I like the work that Meb Faber does in the value space. The Cambria Global Value ETF (NYSEARCA: GVAL ) is remarkably intriguing in theory, though I do not buy assets based solely on low P/Es or low P/S ratios. Russia started the year as the least expensive global equity market, and it only got cheaper. And then there’s the fact that I lived in Asia on and off for roughly 4 ½ years, so the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA: ASHR ), which technically launched in 2013, has also been intriguing. Gaining access to stocks listed in China, the world’s second largest economy, is something that everyone should be thinking about. CP: What do you hope to see from the ETF industry in 2015? Any product filings you are particularly excited to see launch? GG: I anticipate interest in an exchange-traded vehicle that tracks the index that I created with FTSE-Russell, the FTSE Custom Multi-Asset Stock Hedge Index. Obviously, I hope to see it launch because it would be beneficial to me personally, but I am equally hopeful for those who want an alternative to shorting, leverage, inverse funds or T-bills. Let’s be real for a moment. The U.S. economy cannot continue to accelerate if the world continues to decelerate. Investors cannot ignore the mountain of stock overvaluation evidence indefinitely, no matter how many rabbits the world’s central banks pick out of their collective hats. And periods of amplified exuberance always find themselves, later or sooner, at a place of heart-pounding panic. An exchange-traded vehicle for the FTSE Custom Multi-Asset Stock Hedge Index should reduce the anxiety associated with stock downturns. CP: Could you please describe this stock hedge index in more detail? What was your process for developing it? GG: My colleague and I started from a place where we investigated the currencies, commodities, foreign debt and U.S. debt (basically, all non-equity investments), that have a history of exceptionally low correlations to stocks. And then, in combination, demonstrate as close to the holy grail of zero correlation as possible. We looked at performance as well as fund flow movement in times of moderate to severe stock stress. Historically speaking, currencies like the dollar, the franc and the yen – all for very different reasons – have served as admirable hedges. Gold, more or less, had been the commodity of choice. Meanwhile, Japanese government bonds, German bunds and a fairly wide range of longer-maturity U.S. bonds worked remarkably well too. To be clear, owning a fund that tracks this index, or choosing multiple assets to emulate it, is not meant for benchmarking a “bear fund.” Bear funds look to profit from short positions or the stock market falling. The FTSE Custom Multi-Asset Stock Hedge Index is designed to hedge against stock ownership and the risks associated with it. Similarly, owning a single asset like T-bill cash or a U.S. Treasury bond ETF alone does not offer the benefit of diversification across multiple asset avenues. Only now, is multi-asset stock hedging even available in an index. And while it is most likely to perform well when stocks are not… this isn’t a prerequisite. For example, the FTSE Custom Multi-Asset Stock Hedge Index (through 12/15/14) was up 6.5%, even in a year when large-cap U.S. stocks have performed well. CP: Going into 2015, which asset classes are you overweight? Which are you underweight? GG: Remember, we use tactical asset allocation and we are not static buy-n-holders. We are currently overweight U.S. mega-caps through funds like the iShares 100 ETF (NYSEARCA: OEF ) and the Vanguard Mega Cap Growth ETF (NYSEARCA: MGK ), as well as U.S. minimum volatility through iShares USA Minimum Volatility ETF (NYSEARCA: USMV ). And yes, I believe “low vol” is an asset class, though “low vol” by sector, not by the market at large. Otherwise, you own a whole of utilities and non-cyclicals, rather than a fairly well-distributed mix across the economic segments. I have also been picking through the energy rubbish bin. On the debt side of the equation, much like 2014, we currently own bond assets that have relative value when compared to foreign debt. There is plenty of value in owning the Vanguard Long Term Bond ETF (NYSEARCA: BLV ) and/or the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ). People may think that is nuts, but those are the same folks who completely missed the 2014 boat. So let me toot my own horn on this one, I was one of the very few who said rates would go down, the yield curve would flatten, and that these funds would be big time winners. We also own muni debt via the SPDR Barclays Municipal Bond ETF (NYSEARCA: TFI ) as well as closed-end funds like the Blackrock MuniAssets Fund (NYSE: MUA ). I have been underweight small caps, foreign, emerging since July of 2014. And while I own held-to-maturity high yield bond investments in the Guggenheim Series, in general, widening credit spreads have made me steer clear of high yield bonds. CP: What advice would you give to a ‘do-it-yourself’ investor in the present investing environment? GG: Be mindful of where things stand. We are talking about the fourth longest bull market since 1897. The other three? They did not make it past eight years. Either we will break records with this bull market, or more likely, we will see a bear market in 2015 or 2016. The problem is not participating in stocks during periods of amplified exuberance and overlooked overvaluation – that’s how money was made in the ’90s and in the mid-2000s. So you should definitely participate. The problem is failing to take action to minimize downside risks – that’s how investors got creamed in 2000-2002 and 2008-2009. Whether someone does it for you or whether you do it yourself, you must have a plan to avoid the bulk of an upcoming disaster. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.