Using CAPE to Forecast Country Returns for Designing an International Country Rotation Portfolio

Abstract

The cyclically adjusted price-to-earnings ratio (CAPE), though originally derived for the US equity market, has now been calculated for various national equity markets outside the United States. In all its various adaptations, the measure has been used only to express valuations of those markets in terms of being overvalued, undervalued, or fairly valued. None of the adaptations of the measure have been used to derive finite equity return expectations from those markets. This article explores the approach of applying CAPE to develop a computable forecast measure, called the medium-term country yield forecast (CY-M), to express the medium-term real return expectations of national equity markets. In almost all of its past adaptations, CAPE has mostly been used to express only long-term (periods greater than 10 years) valuations of the equity markets, but the author here has explored its application in the medium term (periods between 2 and 10 years). Drawing conclusions from empirical studies on countries in the MSCI All Countries World Index ex. USA (ACWX) for the period 1969 through 2016, the author has amended the CAPE of a national equity market by coalescing it with the cyclically adjusted real exchange rate (computed in the same manner as CAPE) of the country and the long-term price return momentum (adjusted for inflation) of the market. The author also has applied CY-M derived from the adapted CAPE as a comparative measure to screen and rank countries in the ACWX to construct an international country rotation equity portfolio. TOPICS:Portfolio theory, portfolio construction, equity portfolio management, international investing Key Findings • The article illustrates how to adapt CAPE (also known as Shiller’s PE), a popular long-term US equity valuation measure, to be an equally proficient medium-term valuation measure for countries outside the United States. • It elucidates further a mechanism of applying the modified CAPE of a country to frame its medium-term return expectations. • The article also demonstrates how to rank countries based on their medium-term return expectations to construct a country rotation international equity portfolio.