If you buy a market when it’s cheap, the chances are better you’ll make more money than if you buy a market when it’s expensive. But the way most investors use to measure whether a country’s stock market is “cheap” isn’t the best way.
Whether a market is cheap or expensive depends on its valuation. One common approach to valuation is to look at the price-to-earnings(P/E) ratio. For an individual stock, computing the P/E ratio involves dividing a company’s share price by its earnings per share. For example, a company whose shares trade at S$100 and that earns S$25 per share has a P/E ratio of 4. If the share price of a stock goes up while its earnings stay the same, the P/E ratio goes up… and if the earnings go up but the share price stays the same, the P/E ratio goes down. A lower P/E ratio means a stock is cheaper.
For an entire stock market, calculating the P/E ratio is a similar process. It involves finding the weighted average P/E of all the stocks that make up a stock market index. So, a large company’s P/E ratio is going to count for more in the overall market’s valuation than a small company’s P/E ratio because it has a higher weighting in the index.
There are a lot of ways to value a stock, or a stock market, besides the P/E ratio. You can also compare the share price of a company to its book value (the value of a company’s assets minus the value of its liabilities) per share. This is called the price-to-book value ratio (P/BV).
One of the problems with measures like P/E and P/BV is that they’re just a snapshot. Factors like the economic cycle can affect company, and market, earnings in any given year. A big company, with a heavy weighting in the market, might have a bad year, throwing off the whole market’s P/E ratio. The weather could hurt some companies’ earnings, and pull down the earnings of the market as a whole. The commodities cycle can have a large effect on commodity companies…and on it goes. So, the P/E ratio is helpful – but it can be deceptive, too.
A better way than using just the P/E ratio is to adjust the earnings for these kinds of cycles. One way to do this is to take the average for ten years of earnings (rather than just one year, like with the P/E ratio), and adjust them for inflation, to calculate the cyclically adjusted P/E ratio (CAPE). This smoothes out the cyclicality of a single year P/E. It’s more difficult to calculate, but it’s a more complete valuation measure than the normal P/E ratio.
The differences between a market’s normal P/E and its CAPE can be large. For example, the P/E ratio of the S&P 500 (based on next year’s expected earnings) is 16. But its CAPE is 25. That means the U.S. market is expensive when you take into account where U.S. companies are in the earnings cycle. The differences between a market’s normal P/E and its CAPE are often a lot smaller. (Particularly bad years for an economy – like during the global economic crisis – can result in a collapse in company earnings, which can distort the CAPE.)
Studies have shown that buying a stock market (using an exchange traded fund (ETF), for example) with a low CAPE generally results in much better returns than buying a stock market with a high CAPE. Of course, this is the same for stocks… all else being equal, your odds of making money improve when you buy a stock that’s cheap, rather than a stock that’s expensive.
Right now, the world’s cheapest stock markets on a CAPE basis are Brazil, Russia and Peru. The cheapest developed markets are Portugal, Spain and Singapore, with a CAPE of 11.4.
By comparison, China’s stock market according to CAPE is 12.4. Hong Kong is at 14.8.
But just because a market is cheap (low CAPE) doesn’t mean that it won’t stay cheap, or get even cheaper. And just because a market is expensive (high CAPE), it doesn’t mean it won’t get more expensive. And valuation is just one of many things that investors consider when buying shares, or a market.
But valuation is a good place to start. If you’re interested in learning more, check out the ETFs for Brazil (ticker: EWZ), Russia (RSX) and Peru (EPU). There are also ETFs for Portugal (PGAL), Spain (EWP) and Singapore (EWS). All these ETFs trade on the New York Stock Exchange.