Traders work on the floor of the New York Stock Exchange during morning trading on Nov. 2.Michael M Santiago/Getty Images/Getty Images
There’s no shortage of strategies peddled to beat the U.S. stock market. Some sing about day-trading software. Others tout their stock-picking genius “available now through this newsletter for just $599 a year.”
There is one strategy that really should thump U.S. stocks over the next 10 years, but it takes a special kind of person to make it work.
No, you don’t have to be smart and you don’t have to live and breathe the markets. You could forget about what’s happening in the economy right now, and all forecasts. You could also ignore politics, wars, recessions, currency dives and inflation.
Most importantly, you would need to ignore short-term returns. And by short-term, I mean anything less than a decade.
Could you do all that? Most investors can’t. It requires patience and nerves of steel.
The strategy is to buy country-specific exchange-traded funds (ETFs) with low cyclically adjusted price-to-earnings (CAPE) ratios. The method, also known as the Shiller P/E ratio since it was devised by Robert Shiller, is calculated by dividing a company’s stock price by the average of the company’s earnings for the last 10 years, adjusted for inflation.
It’s a bit like a traditional P/E ratio – which divides a stock’s current price by its latest earnings per share – but more strict.
With the traditional P/E ratio, a stock could look cheaper, or more expensive, if the company recorded a year of unusually high or unusually low earnings the previous year. With a CAPE ratio, the current market price is compared to its average earnings over a longer, more reliable timeframe.
Dr. Shiller found that when a country’s stock market CAPE ratio was significantly higher than its historical average, that country’s stock market typically earned a poor return over the next 10 years. In contrast, when a country’s CAPE ratio was lower than its historical average, that boded well for the decade ahead.
As referenced by Robert Shiller and Farouk Jivraj in the 2018 paper, The Many Colours of CAPE, when a starting period for the S&P 500 began with a CAPE ratio between 5.6 and 9.6 times earnings, the S&P 500 earned total 10-year returns that beat inflation by between 4.2 per cent and 9.8 per cent per year.
When the CAPE ratio began a 10-year period between 13.9 and 16.1 times earnings, the decade that followed didn’t always beat inflation. Total real (after inflation) returns averaged between -1.6 per cent and 7.8 per cent per year. And when the CAPE ratio was between 26.4 and 44.2, the decade that followed recorded total annual real returns between -6.1 per cent and 0.9 per cent per year.
It’s important to note, however, that we can’t compare one country’s CAPE ratio with another to determine whether one has better future prospects. Instead, we need to compare each respective country’s CAPE ratio with its historical average CAPE.
The S&P 500 Index, which is U.S. stocks, dropped by about 19 per cent year to date as of Nov. 1, according to Morningstar. But with a CAPE ratio above 28 times earnings, they are still expensive by historical standards.
I’m not saying you shouldn’t own a globally diversified portfolio that includes U.S. shares. But if you want to roll some dice to beat the U.S. market, one speculative method has more merit than the rest.
Using Barclay’s Historic CAPE Ratio by country assessment, we can find several countries trading close to or below their historical averages. If we diversify with a basket of nine ETFs, we have strong odds of beating the U.S. stock market.
But this strategy takes a superhuman stomach. Your gut will tell you to run from these funds. But if you can ignore your gut, ignore economic news and shackle a desire to see quick results, the odds are good this will work.
Each of the following ETFs trade on the New York Stock Exchange, starting with the iShares MSCI Germany ETF (EWG). Its CAPE ratio is below 16 times earnings. Ten years ago, it was 18.08. The plunging Euro, the war in Ukraine and the influx of refugees from war-torn nations have sucked the wind out of German stocks.
But don’t expect German stocks to soar this year or next. CAPE ratios aren’t strong predictors of short-term results. However, they have been the world’s best forecasters over a decade.
That means German stocks could rise this year. Or, they could sink or flat-line for seven or eight years before they take off. Meanwhile, by adding money now, when they’re cheap, investors can buy more units at a discount and enjoy a dividend yield above 5.4 per cent.
Instead of banking on a single, cheap ETF, however, even contrarian investors should make sure they diversify. Hong Kong shares are also cheap. With a CAPE ratio of about 15 times earnings, that’s lower than it was 10 years ago. Investors could gain access to this market with the iShares MSCI Hong Kong ETF (EWH-A).
Korean shares, which you could purchase through the iShares MSCI Korea ETF (EWY-A), are also on sale after dropping 32 per cent this year to Nov. 1. Their CAPE ratio, at about 13 times earnings, is almost 20 per cent lower than it was 10 years ago.
Polish shares might be under the greatest pressure based on the country’s proximity to Russia and Ukraine. The iShares MSCI Poland ETF (EPOL-A) is down almost 40 per cent this year. The country’s CAPE ratio sits at roughly seven times earnings.
Investors could round out these deep-value plays with five other country-specific ETFs. They include the iShares MSCI China ETF (MCHI-Q); iShares MSCI Singapore (EWS-A); iShares MSCI South Africa ETF (EZA-A), and iShares MSCI Turkey ETF (TUR-Q). Turkish stocks gained about 52 per cent this year, to Nov. 1 but, like the other eight countries above, Turkey trades at a lower CAPE ratio than its historical average.
As a group, if we bought these ETFs, ignored their short-term prices and held them for a decade, they would have an excellent chance of beating the U.S. market. The only question is, would you have the guts to stay the course?