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Where to Look for Cheap Stocks in 2015: CAPE Around the World

2014 was a lousy year for global value investors. Cheap markets, as measured by the cyclically-adjusted price/earnings ratio (known by the acronym “CAPE”), got even cheaper, while expensive markets got even pricier. Note: The CAPE ratio is calculated using a ten-year average of earnings as a way of smoothing out the economic cycle and allowing for better comparisons over time.

I expect this to reverse in 2015. At some point and Im betting it could be as early as the first quarter global market valuations should start to revert to their long-term averages. Thats fantastic news if youre invested in cheap foreign markets. Its not such fantastic news if your portfolio is exclusively invested in high-CAPE American stocks.

A Look at the Returns

Lets take a look at just how skewed the numbers are. The S&P 500 managed to produce total returns of 13.7% in 2014. But as quant guru Meb Faber pointed out in a recent blog post. globally, the median stock market posted a loss of 1.33%. The cheapest 25% of countries saw declines of 12.88%, while the most expensive markets actually gained 1.36%.

I should throw out a couple caveats here. These were the returns of U.S.-traded single-country ETFs, which are priced in dollars not the returns of the national benchmarks. The strength of the U.S. dollar relative to virtually every other world currency last year was a major contributor to the underperformance of the rest of the world.

All the same, its worth noting that were in uncharted territory here. As Faber observed in a recent tweet , U.S. stock valuations relative to foreign stock valuations closed 2014 at the highest spread over the past 30 years. Four out of the five biggest relative valuation gaps resulted in outperformance by foreign stocks the following year. The only exception was 2014.

Lets dig into the numbers. The CAPE for the S&P 500 is now 27.2. Thats a full 63.9% higher than the historical average of 16.6. more expensive than at the 2007 peak, and close to the 1929 peak. The only time in U.S. history where the S&P 500 was significantly more expensive based on CAPE was during the peak of the 1990s tech bubble.

Sure, the fair CAPE is going to be a little higher today than in decades past due to record low bond yields (all else being equal, lower yields mean higher correct valuations). But I should point out that yields are even lower in most of Europe and Japan, yet valuations are significantly cheaper. So while low bond yields might partially explain why U.S. stocks are expensive relative to their own history, it doesnt explain why the U.S. is expensive relative to the rest of the world.

U.S. Stocks Are Expensive

No matter how you slice it, U.S. stocks arent the bargain they were a few years ago. Research Affiliates calculates that U.S. stocks are priced to deliver returns of about 0.7% over the next 10 years. Using a similar methodology, GuruFocus calculates an expected return of about 0.3% .

Ive driven home how expensive U.S. stocks are. Now, lets take a look at other global markets. Here are the worlds cheapest stocks as measured by the CAPE and sister valuation metrics cyclically-adjusted price/dividend (CAPD), cyclically-adjusted price/cash flow (CAPCF) and cyclically-adjusted price/book (CAPB).  All figures reported in Meb Fabers Idea Farm using original data from Ned Davis Research.