International stocks are on a tear this year. Vanguard’s Total International Stock Market Index (VGTSX) is up 17.13 percent to August 10, 2017. Vanguard’s Emerging Markets Index (VEIEX) has gained a whopping 19.54 percent. So far, both foreign index funds are leaving U.S. stocks behind. Over the same time period, Vanguard’s Total U.S. Stock Market Index (VTSMX) is up just 9.28 percent.
I didn’t see this coming. But it didn’t surprise me either. On December 28, 2015, I wrote, The Best Bargain Index Funds That Everyone Should Own. Compared to U.S. stocks, I wrote that international stocks were cheap. I said some big gains were coming.
I based that theory on something called a cyclically adjusted price-to-earnings ratio (CAPE). Yale University professor, Robert Shiller, created CAPE ratios as a strict measurement of price. It’s a tougher yardstick than a typical price-to-earnings (PE) ratio.
PE ratios are a bit like a 3-point tennis match. They don’t always reveal what’s cheap or expensive because they only focus on a company’s single year earnings.
To determine a company’s trailing PE ratio, we divide its current stock price by its previous year’s earnings per share. The table below shows a few examples for a company that we’ll call, Cabbage Patch. If the stock’s price were $20 in 2013, and the previous year’s earnings per share were $1, then Cabbage Patch’s PE ratio would be 20 (20 divided by 1 = 20).
But an unusually strong year could create an artificially low PE ratio. If Cabbage Patch traded at $30 in 2014, and if its earnings-per-share (EPS) had jumped to $2.25, the PE ratio would be 13.33 times earnings.
That might look a lot cheaper than the previous year. But if the jump in earnings per share came from a one-time event, the low PE ratio might be artificial.
If the stock price sank to $25 in 2016, and earnings dropped to something normal ($1.20 per share) the PE ratio would be 20.83 times earnings. But would Cabbage Patch stock really be more expensive?
How Are PE Ratios Determined?
|Year||Stock Price||Earnings Per Share||PE Ratio|
The late, great stock picker, Benjamin Graham, saw the problem of putting too much emphasis on current year earnings. As the author of The Intelligent Investor, Graham said investors should average a company’s earnings over a seven year period. By doing so, unusually good or bad years wouldn’t fool investors.
Robert Shiller’s CAPE ratio does something similar. It averages inflation-adjusted earnings over a ten-year period. It isn’t usually meant to determine the price of a company’s stock. More often, it’s used to show the overall price of a given stock market.
Shiller found that when stocks trade well above their historical average CAPE levels, they usually stumble in the decade ahead. Below average CAPE levels, however, often lead to a decade of prosperity.
According to StarCapital Research, U.S. stocks averaged a historical CAPE level of 16.6 from 1881 to 2016. Note the dark grey measurement near the bottom of the chart below. It looks like a mountain range, representing changing CAPE levels over different years. As the chart shows, CAPE levels exceeded 32 in 1929/1930. U.S. stocks (as seen by the red line) struggled for at least a decade after that. CAPE levels hit an all-time high in the late 1990s. U.S. stocks, as shown in the chart, also struggled for about ten years after that.
On June 31, 2017, the CAPE level for U.S. stocks stood at 28.0. That’s far above the market’s average CAPE level of 16.6.
But don’t compare CAPE ratios for different stock markets, using U.S. data from 1881. CAPE level data for most international markets wasn’t available until about 1979. A lot has changed since 1881.
To show an equal playing field, I’ve listed historical CAPE levels for different countries (including the United States) since 1979. I’ve also shown current CAPE levels and determined whether each respective market is overpriced, unpriced (or neutral) based on price levels on June 31, 2017. For example, if a stock market were trading 15 percent above its historical CAPE average, I listed it as overpriced. If it were 15 percent below its historical level, I listed it as underpriced.
U.S. stocks have averaged a CAPE ratio of 21.4 since 1979. On June 31, 2017, the U.S. stock market’s CAPE level was 28 times earnings. That’s 30.84 percent higher than the country’s average CAPE level since 1979, so I listed U.S. stocks as overpriced.
CAPE Ratios Around The World
|Country||Historical Average Since 1979||Current CAPE Level||Under-priced or over-priced|
| *France, since 1981 |
Sources: StarCapital Research January 2016, Long-Term Stock Market Expectations
Using CAPE level data from June 31, 2017
That said, this isn’t a perfect measurement. Japanese stocks, for example, hit such nosebleed heights in 1997 that the country’s historical average CAPE (since 1979) is still an eye-watering 43.2. That’s why it’s current level of 26.2 might still be expensive, despite sitting below its historical average.
Overall, however, international stocks should still be considered cheap.
According to Star Capital Research, the MSCI countries have an overall CAPE level of 21.0. That’s below their CAPE average of 22.3 since 1979. What’s more, the United States makes up a large portion of the MSCI World Index. That means broad international stock market indexes offer a good deal.
This year, so far, international stocks have soared. But based on low valuations, they might still have plenty of room to run.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas