CAPE Around the World Update 2015 – Return Differences and Exchange Rate Movements
Wellershoff & Partners Ltd.
July 4, 2015
[klarman]
Abstract:
We update our annual analysis of expected returns for 38 equity markets around the world. For the first time since we started our series in 2012, we find most emerging markets now exhibit higher expected returns than developed markets. In particular the expected returns for the core European stock markets of Germany, the UK and Switzerland have declined after strong performances of 2014 and early 2015. For many of these markets, expected returns are now at or below historical averages, but still significantly above the mediocre returns expected for the US stock market.
In this study we examine the significant differences between expected returns in different countries. We demonstrate that exchange rate movements exert a considerable influence on stock market returns. Contrary to common belief, exchange rate movements also matter for longer investment horizons of, say, five to ten years. We show how stock market valuation differences correlate with exchange rate movements, and perhaps surprisingly we show that CAPE differences between two countries offer some insight into their long-term exchange rate trends. One likely outcome of our analysis is that over the next five years European stock markets will likely show higher returns in euros than do US markets in dollars. We would quickly add that exchange rate movements may reduce the effective return difference when calculated in a common currency such as the euro or the dollar. Thus, to reap the full benefits of a global equity investment strategy, US investors should use currency-hedged investments to avoid losses from devalued foreign currencies.
CAPE Around The World Update 2015 – Return Differences And Exchange Rate Movements – Introduction
When we started this series in 2012 we evaluated the accuracy of CAPE – the cyclically adjusted price-to-earnings ratio also known as the Shiller-PE – for assessing the equity market valuations in various countries. Despite differences in accounting standards, market transparency and liquidity, CAPE proved to be a reliable predictor of long-term equity market returns in both developed and emerging markets (Klement [2012a, 2012b]).
We also introduced the concept of the “macroeconomically fair CAPE.” This metric takes into account the current interest, inflation and growth rates in our sample countries to yield a “fair” valuation level. As we have shown in Klement [2013] and Klement and Dettmann [2014], today’s prevailing very low interest rates and low inflation largely explain the current high valuation levels. However, there are some equity markets that seem overvalued even when low interest rates are taken into account. Indeed, we conclude that most equity markets presently show significant risks of drawdowns over the coming five years – particularly if interest rates start to normalize.
This year’s CAPE update takes a closer look at the seemingly large differences between CAPE and expected returns in different countries. As we will show in the second half of this report, one important influence on both CAPE and realized stock market returns is the exchange rate of the local currency versus the US dollar and other currencies. Exchange rate shifts between currencies impact both corporate earnings and investors’ returns in a given market. Many investors think that, over the long run, exchange rate movements can largely be ignored, but as we will show, even for investment horizons of five to ten years, exchange rate movements can have a significant impact that needs to be taken into account.
Perhaps surprisingly, we also show that differences in CAPE often correlate to future exchange rate movements. The current differences in CAPE and expected returns between the US and European stock markets suggest the euro will experience a marked downtrend against the dollar in the coming years. In the last section of this paper we summarize our findings on the impact of currencies on international stock market returns and we discuss some implications for investors. But first we present the current valuations and expected returns of our 38 global equity markets.
Developments over the past year
We update CAPE for the 38 developed and emerging markets in our sample through June 2015 (sees Exhibits 1 and 2). Exhibit 1 shows the current valuation levels for developed markets as well as our macroeconomically tuned fair CAPE for these countries, and the difference between the two, expressed in percent. The macroeconomically fair CAPE estimates where the CAPE for each country should be if current rates of interest, economic growth and inflation are considered. For comparison we also show these deviations from June 2014, presented in Klement and Dettmann [2014]. Compared to 2014 we conclude that a rising valuation tide has lifted all boats. Markets that were overvalued compared to our fair CAPE in 2014 tend to be even more overvalued today. In turn, markets that were undervalued tend to be less undervalued today, some having turned an undervaluation into a fair valuation (Italy) or even a slight overvaluation (France). The changes seem particularly pronounced in Eurozone countries where the European Central Bank’s launch of quantitative easing led to a significant stock market rally in early 2015. Since earnings are improving in the Eurozone, but at a much slower pace, some significant increases in CAPE have been recorded.
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