Top
Commentary

Belgium, France, Germany and the Netherlands have attractive CAPE

27 Jul 2012 by Jim Fickett.

Fear over the debt crisis has driven down European stocks. The Shiller cyclically-adjusted price earnings ratio (CAPE) suggests that the fear has produced a real opportunity.

Mebane Faber at World Beta pointed on Monday to an interesting paper entitled, Does the Shiller-PE Work in Emerging Markets? The author, Joachim Klement, evaluates the usefulness of the Shiller CAPE in 35 national markets. Despite the title, most of the countries considered are developed, and the emphasis is as much on them as on those considered emerging. Here is the abstract:

We test the reliability of the Cyclically Adjusted PE (CAPE) or Shiller PE as a forecasting and valuation tool for 35 countries including emerging markets. We find that the Shiller-PE is a reliable long-term valuation indicator for developed and emerging markets and we use the indicator to predict real returns on local equity markets over the next five years.

The data available is of varying usefulness. For example, for many countries there is only a few years' worth of data available, too little to really evaluate. And the correlation of Shiller CAPE with the returns in following years is much better for some countries than others. In an effort to make use of only the most solid results, I narrowed the field to countries in which there was at least 20 years' worth of data, R2 was at least 0.5, and 5-year expected returns based on CAPE were at least 10 percentage points better than for the US.

This still left eight countries to consider, which is too many to look into in any detail. Klement shows that macroeconomic conditions together with CAPE improve the returns prediction, and he presents expected returns in each of several economic scenarios (the most likely of which is the worst, namely low growth and rising interest rates). I further narrowed the field to countries that did not have significant expected losses in any of the economic scenarios. This reduced list is the one in the title of the post – Belgium, France, Germany and the Netherlands.

The US market, which is seriously overvalued on the whole despite many reports to the contrary, has the worst expected returns of any developed nation, and has 5-year expected returns of -25% in the (very likely) scenario of slow growth and rising rates. So for Americans who don't have the time to pick individual stocks, but want to hold equities, it would make sense to consider other countries.

Of the four countries that look attractive, I happen to know the most about the companies of France. Klement plots CAPE against subsequent returns for all countries considered, and the chart shows excellent correlation for France. Predicted 5-year real returns are 52%, with the worst scenario coming in at 13%.

So I took a quick look for an appropriate vehicle. There is one, an ETF from iShares: MSCI France Index Fund (EWQ). This looks to be a pretty reasonable fund. It is intended to track the entire French market, and holds 74 stocks in order to track the full index fairly broadly. The tracking history since fund inception in 1996 looks excellent, and the management fee is only 0.52%. If I were to take a position in EWQ, the part that would make me most nervous would be the banks, which are heavily exposed to peripheral Europe. But the ETF is only 12.6% financials, so this is not a deal-killer.

On the whole I find an investment in EWQ an interesting proposition. There is little doubt there are likely to be some scary moments for any investment in Europe, but the CAPE is a pretty objective indicator, there are many strong and competitive French companies, and France has a long history of coming through various crises and flourishing afterwards. And remember, things looked awfully bleak in the US in 1929, but it was a great time to invest for the long term.

Note that while many commentators are advising against investment in Greece, or Spain, or France because the government is in trouble, companies are not governments. Yes, if France has a debt crisis it will be bad for business. But one has to separate the question of what value to place on all future company earnings from the fear of government debt costs getting out of control. They are not independent issues, but they are not the same thing, either. It is quite possible that a government could default while companies in that country came through, in the end, just fine.

This would be an unusual move for me, so I will mull it over for a while. Any thoughts?