Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.
The S&P 500 has dropped about 10 per cent since July 20. That's a promising start, if you're looking for a market deal. U.S. stocks, however, need to fall further before bargain hunters dance.
Yale University professor Robert Shiller developed a price-to-earnings ratio that measures a stock's price, relative to a company's cyclical business earnings. It's called a cyclically adjusted price-to-earnings ratio (CAPE). It compares stock prices with 10 years of real earnings. It's a much tougher measuring stick than a typical PE ratio, which can be affected dramatically by an unusual level of earnings in a single year.
Based on this measurement, U.S. stocks are still expensive. On Aug. 31, Joachim Klement, the chief investment officer at Wellershoff & Partners Ltd., calculated the U.S. market's CAPE level at 23.1. The average historical CAPE for U.S. stocks is about 16.4. Prof. Shiller found that when a stock market's CAPE level greatly exceeds its historical average, returns for the decade ahead disappoint. Markets trading far below their historical CAPE levels often enjoy strong returns for the decade that follows.
U.S. stocks have fallen. But there's a better deal at home. The S&P/TSX composite index has dropped almost 11 per cent over the past 12 months. According to Mr. Klement, its CAPE is 18.2. That's below its historical average of 19.3. So the Canadian market trades at a 6-per-cent discount.
Looking for better deals? Investors with the courage to run away from the herd can often scoop bargains. Long term, stock markets are efficient. Short term, however, markets can be bonkers. When investors are wildly optimistic (think of the dot-com bubble) prices usually soar higher than they should. Stock market corrections bring levels back to Earth.
The opposite occurs when investors are glum. Take German stocks in 2011. Gross domestic product dropped. Energy prices rose when the government said no to nuclear power. German companies were said to be moving abroad. That year, German stocks were among the worst in Europe. They dropped 17.5 per cent. Pessimism went too far – as it often does. In 2012 and 2013, German stocks gained 32.1 and 32.4 per cent respectively.
Few investors have the courage to dive into pools when others are climbing out. One such pool is Greece. Today, it's the world's cheapest market. Its average historical CAPE level is 18.2. Today it trades at 2.1. Investors jumping into Greek shares could buy the Global X FTSE Greece 20 ETF (GREK). Measured in U.S. dollars, it's down 55 per cent since September, 2014.
Five other stock markets trade at least 40 per cent below their historical CAPE levels. They include Austria, Italy, Spain, Colombia and Peru.
Among developed world markets, Austrian stocks are cheapest. Their historical average CAPE is 25.4. They now trade at 9.4. Austrian stocks have been dogs before. In 2008, the Austrian market dropped 50.09 per cent. Only Hong Kong did worse. It fell 51.2 per cent. But in the four years that followed, Austrian stocks were stars. They gained 124 per cent between 2009 and 2012. Investors wanting to add Austrian shares could buy the iShares MSCI Austria Capped ETF (EWO).
The Italian stock market is also cheap. Its historical CAPE is 20.2. It now trades at 10.8. Investors could buy the iShares MSCI Italy Capped ETF (EWI), which also trades on the U.S. market.
Spanish stocks offer the next best bargain. Their historical CAPE is 16.7. But they now trade at 9.1. The iShares MSCI Spain Capped ETF (EWP) is down 23 per cent since September, 2014. It also has its own Cinderella story. In 2005, most global markets earned double-digit returns. Spanish stocks didn't. After earning just 4.9 per cent, they were among the world's worst performing markets.
But they spun heads in 2006. With a 50.2-per-cent gain, they beat every stock market in the developed world. From 2006 to 2009, Spanish stocks were among the top five performing markets, every single year. No other stock market achieved that feat.
Two other markets trade at half their historical CAPE levels. They include Colombia and Peru. The iShares MSCI Colombia Capped ETF (ICOL) has dropped 56 per cent over the past year. To tango with Peru, you could buy the iShares MSCI All Peru Capped ETF (EPU). It's down 36 per cent over the past 12 months.
These bargains are tempting. But they are also risky. Put your investment house in order before flirting with these deals. Make sure you have a Canadian stock market index, a Canadian bond market index, and an index with U.S. and international stocks. These indexes should represent at least 90 per cent of your portfolio's total value.
ETFs trading at steep market discounts could make up the remaining 10 per cent. Just remember to rebalance. Global markets take turns: flying near the top and floundering near the bottom.