Equity Portfolio Rebalancing: Finding Opportunity for Value in Today’s Markets
Equity markets currently present a bit of a quandary. This year, US stocks have rallied to new all-time highs while European equities recently surpassed levels not seen since 2008. Even Canadian stocks, which have lagged their international counterparts, reached a two-year high late last month. If the essence of investing can be boiled down to “buying low and selling high”, at first glance recent performance would suggest that there would be little opportunity to do so.
Enter the value investor. You may recall that earlier this year we described the value investment approach, which entails finding companies trading at low valuations, either relative to their historical levels or to similar firms. The price-to-earnings ratio (or P/E ratio for short) is the most widely followed and reported tool. With markets hitting multi-year highs despite slowing earnings growth, P/E ratios have reached a point where some think stocks could be overvalued.
Of course, the standard P/E ratio, considered in isolation, can be misleading. Benjamin Graham, considered the “father of value investing”, observed that these figures could be affected by short periods of high or low profits. As a result, he proposed a ratio that considered the full range of earnings power over an entire business cycle. In modern times, Robert Shiller – one of three scholars to be awarded the Nobel Prize in Economics last month – built on Graham’s insight to develop the cyclically-adjusted-price-to-earnings ratio (or CAPE ratio for short). This metric smoothed the volatility of P/E ratios by measuring the price of stocks relative to their average inflation-adjusted earnings over the last ten years..
Interestingly, evidence in the US stock market has shown that the CAPE ratio does have some power in forecasting subsequent returns. Like two ends of a lever, when the metric is higher than average, returns in the following years tend to be lower. While the metric has very little applicability to short term movements, over periods of ten years or more the inverse correlation between the starting CAPE ratio and returns is remarkably strong.
The chart above depicts the results of a recent study by Wellershoff & Partners, an economic research firm. Their analysis found that a one point increase in the CAPE ratio – for example from 18 to 19 – led to a 3% decrease in the real return per year over the following decade. With the US CAPE ratio above its long-term average (currently around 24 versus a four decade average of 18.7), over the next decade the study forecasts a mere 2.52% return per year after inflation. Closer to home, the latest CAPE ratio for Canadian stocks is 17.9, which is below the four decade average of 19.2. As a result, Canadian equities are expected to outperform with an annual return of 4.17% after inflation over the next 10 years. Interestingly, European and Emerging Market stocks present the most opportunity according to current CAPE ratios. With figures of 13.8 and 12.7, respectively, investing in these markets today represent the best chance to “buy low and sell high”.
It is true that even with its improvements, looking at the CAPE ratio in isolation can be misleading. While it does a pretty good job at putting today’s valuations in a historical context, it cannot be relied upon to time the market. For example, the US CAPE ratio was over 26 in 2004, yet stocks continued to rally more than 40% before correcting in 2008. Nonetheless, the findings of this study are intuitive. It shows that entry points often matter in investing. With this in mind, although markets around the world are currently hitting their highs, there are still opportunities for a globally diversified portfolio. This is another reason why T.E. Wealth continues to believe in the value of portfolio rebalancing.