Episode #3: Co-host: Jeff Remsburg – Where Are Best Global Values Right Now?
Guest: Episode #3 has no guest, but is co-hosted by Meb’s co-worker, Jeff Remsburg.
Topics: Is right now a good time to be in U.S. stocks? What about global stocks? Well, the answer in large part depends on the specific market’s valuation. Start investing in an overpriced market and your returns will likely be small. Start in a cheap market, and it’s more likely you’ll enjoy outperformance. So where are we today? And what does it mean for where you should be invested? Meb tells us in this episode, pointing out the most expensive and cheapest markets around the globe. He also asks “What percentage of your stock allocation is in the United States?” Want to know the average answer Meb gets when he asks that question to professional money managers? The answer will surprise you. Find out what it is on podcast #3.
Episode Sponsor: TheIdeaFarm.com
To listen to Episode #3 on iTunes, click here
To stream Episode #3, click here
Comments or suggestions? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- – Global Value – Meb Faber
- – Shiller Excel download
- – Intelligent Investor – Ben Graham
- – Security Analysis – Ben Graham
- – Irrational Exuberance – Robert Shiller
- – “Who Ate Joe’s Retirement Money” – GMO
- – “High Valuations Indicate Higher Downside Risks” – Star Capital
- – “Drawdowns vs. PE” – Meb Faber
- – Star Capital CAPE Updates
- – Research Affiliates CAPE Updates
- – “Why The Bear Isn’t Probably Over Yet” – Meb Faber
- – Zulauf on his favorite idea
- – “Global Valuations in 2016” – Meb Faber
- – “Ranking Markets on Valuation” – Meb Faber
- – “Investing in High Dividend Years” – Meb Faber
- – “Time to do a Templeton” – Meb Faber
- – “Five-Year Returns When Shiller P/E Dipped Below 10” – Research Affiliates
Running Segment: “Things I find beautiful, useful or downright magical”:
Selected Charts for Episode #3:
Transcript of Episode #3:
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Meb: Welcome to the Meb Faber show, friends, this is your host, Meb Faber. Today this is episode three, we got a few episodes in the bag. The first one if you guys remember, was me just kind of riffing on global asset allocation. The second one, we had a great guest, a whopping hour and a half episode with Patrick O’Shaughnessy. Today we’re going to mix it up, and try something a little different. I’ve invited a co-host with me here today. And depending how it goes, Jeff may be joining us from here on out. Quick intro, Jeff Remsburg joined our company in January. Going along with the thread of our company being pretty diverse, we have a lawyer, a former venture capitalist, my background was in bio-tech, we have a civil engineer. Jeff has a medley of background. He has a former MBA, worked in real estate, was on a little known television production called The Office, and is also a former bassist.
Jeff: That’s right, I am a bit of a chameleon so…
Meb: And one day we’ll make him tell the story about how he stole all James Taylor’s doughnuts one day too. And then on top of that, Jeff is a Carolina Tar Heel. I’m a Virginia Cavalier, as many as you know. So, Jeff, welcome to the show.
Jeff: Thank you. Glad to be here.
Meb: So today I figure we’ll talk a little bit about a different topic, a different book that we’ve put out, and a speech we’ve given a lot over the past few years, and that’s a topic of global stock market valuations. And this is a interest to a lot of people as they think about markets, whether they’re efficient. But particularly, thinking about investments in the term of, is this a good time to be in stocks? Is it a better time to be in foreign stocks? Are there bubbles going on? Are there booms or busts? So I figure we’ll go through this speech. Feel free to ask me any questions, interject at any point, and we’ll go from there. Sound good?
Jeff: Sounds great.
Meb: Great so, before we start, this is a question I’ve asked every time I’ve given this speech in the past few years. So if you’ve heard me give a talk, ignore this question. You already know the answer, you could skip ahead. We pass around a piece of paper. If the room’s too big, if there’s more than a few hundred people, we don’t do it, but we say, “Think about the answer to this question.” And the question is what percentage of your stock allocation is in the United States? Or if you live in Italy or somewhere else, consider your own home country. Ignore bonds, ignore REITS, ignore commodities. How much of your global stock allocation is in the U.S.?
Jeff: I would have to say mine’s around 90%.
Meb: Okay, all right. Well, that’s a reasonable answer, and we’ll come back to that later. But just think about that as we begin this talk. So a little background. What we’re talking about today is nothing new. The basis of this goes back over a hundred years. Pretty famous investor. Many of us have read a lot of his famous books. Columbia professor, Ben Graham, also known as the father of value investing, was writing about value and securities in the early part of the 20th century. What he often talked about was smoothing out earnings of a particular company. He was talking about stocks over five to seven years. So over that period to remove the impact of booms as well as busts, recessions as well as expansions, as a way to come up with a fundamental anchor to value that security.
Just take a step back, take a 10,000 foot view. Well, almost at the end of the century, another famous professor, Robert Schiller who is a recent Nobel laureate at Yale, he wrote some white papers in a famous book, now a handful of books. But he said, “Let’s apply this to the stock market as a whole.” As he said, “Let’s simplify it. Let’s do a 10 year P/E ratio,” price to earnings ratio, and he adjusted for inflation, to be able to say, “I want to compare times in the ’70s when there was a lot of inflation, to times like now when there’s hardly any inflation. And we’re going to call this the,” it’s a mouthful, “the cyclically adjusted price-to-earnings ratio.” But we like to call the CAPE for short. So a lot of people know it as the Schiller CAPE Ratio. He took this all the way back to 1880. By the way for the listeners here, we’ll add a visual accompaniment to this radio chat, so if you want to come look up some of these charts later, I know it’s a little hard if you’re driving, or in the subway.
But look at some of these charts later for a reference. So he built this indicator that goes back to the late 19th century for reference. The average CAPE Ratio value has been around 16 or 17 since the late 19th century. But there’s been many times that this psychotic Mr. Market, has decided that people are willing to pay as low of a value as five. Has been the lowest we’ve seen proceeding and right after the Great Depression. And then it’s hit peaks in the roaring ’20s. Hit a value in the ’30s, and then back and forth, back and forth. It got expensive again in the ’60s. And then was a super low single digit level in the early 1980s, one of the best times to be buying stocks in our lifetime.
And then of course the massive run-up bubble of all bubbles for the U.S. stock market hit a peak of 45 in December 1999. Jeff, do you remember that? Were you trading stocks at this point?
Jeff: I was. I don’t remember using Schiller back then, but I remember being in the market, being excited then being hammered shortly thereafter.
Meb: Pets.com, CNGI, do you remember any of those names?
Jeff: I remember those. I remember the worst for me though was, JDS Uniphase.
Meb: Oh, yeah.
Jeff: I got jack hammered in that.
Meb: JDSU. All right. Well, so then you had this huge sell off, you know, as everyone remembers the markets then rallied for a few years into 2007. And then another huge bear market. What many people don’t know is stocks got quite cheap in 2008, 2009. They got down to a Schiller CAPE Ratio of around 13. So much lower than the historical 17, and since, they’ve run right back up and are now sitting at a value of around 25.
Jeff: One question for you on CAPE, I’ve heard its value, its merits debated from time to time. And I believe your take on it is it’s more of a useful blunt tool rather than a precision timing tool. Is that accurate or am I putting words in your mouth?
Meb: Valuation is not something traditionally that’s going to help you in the next month or even year. And you often have to align your indicator with a time frame that it’s measuring, so in this case its measuring 10 years. So you really, the time frame to be using this for say the U.S. stock market is really what is my perspective for the next 10 years? And so you can actually go back and look to the 1880s and say, “How has this performed when it’s traded at a value say below 10, all the way up to increasing buckets 10 to 15, 15 to 20, 20 to 25 and above 25?” We call those quintiles. No surprising it’s a stair step down, the less you pay for something, the cheaper something is. A valuation below 10, you get double digit returns.
It stair steps all the way down to where you’re in the worst bucket when you pay for over 25 CAPE Ratio you get really low single digit returns. We’re talking about real returns here. You can add on inflation 2-3% historically. But historically when you buy things, and it’s not rocket science, valuation never is. When you buy something that’s cheap, your future returns tend to be high. When you buy something that’s very expensive, future returns tend to be low. One other cool part about using a valuation indicator, and this really applies to buying anything dear or expensive, is that if you have what people call a margin of safety, and buy something that’s cheap, chances are you have this buffer zone where you’re not going to lose a lot of money probably. Whereas if you buy something that’s really expensive, and people can think about this with housing, with cars, whatever it may be, you have a bigger chance of a big fat loss.
And this actually shows up in the data. We’ve written about this, James Montier has written about this. Research Affiliates have written about this. That if you buy something when it’s expensive, the future 10 year, what we call the largest draw down, is much, much higher than if you buy it when it’s in the cheaper buckets. But when we talk about valuation, and kinda back to your question, it’s kind of like playing black jack, or poker, or any other probabilistic outcome game, where many people have probably sat down at a black jack table. And if you play what’s called basic strategy, which is the correct way to play, you’re going to lose, you have about a half a per cent disadvantage to the house, one of the smallest disadvantages in the casino. If you count cards you can move that to about 1%.
Like Bill Gross did back in the day in Lake Tahoe, but in general, you’re still going to lose money of course. However there are times when the odds are much better in your favor, and times when they’re much worse. So for example, let’s say you’re sitting on 10 and a jack. You got a 20, and the dealer has a 6. The probability of that hand is great. You are likely to win. The expected value is going to be great. On the flip side, you may be sitting on a 16, a 10 and a 6, and the dealer has a face card showing. Chances are you’re going to lose that bet. Same thing happens with investing. When you have a Schiller CAPE Ratio in the high single digits, chances are, you’re going to make money over the next 10 years, and vice versa. When Schiller’s expensive, chances are you’re not going to have great returns. But it’s not guaranteed. Think about the ’90s when returns were…I mean when CAPE Ratio was already high.
The way that it gets from a value of 25 to 45, is expensive has to get more expensive, and both things…it works in both directions. So that’s the beauty and also the challenge of investing is that it puts the odds in your favor, but it doesn’t guarantee anything.
Jeff: So are you married to CAPE or just valuation in general? You think are sort of commoditized and you can pick anything and it would all generally point you towards the same direction?
Meb: We like CAPE because it works well. Again, if you have a market, every valuation indicator should be on the same side. They don’t have to say the same thing, but when something’s really expensive or really cheap, they should all agree. So for example. CAPE says U.S. stock market’s expensive, future returns nominal, should be about 4% a year. So not terrible. It’s not a bubble right now, but not great. Much less than historical roughly 10% we’ve come to expect at six and a half percent real, so this is 4% return, not great. However, there’s other indicators, so let’s look at one of my favorites. This is a Ned Davis chart where it looks at the median price-to-sales ratio in the S&P 500. So that’s the middle stock in the S&P 500, number 250. It’s trading at a price-to-sales right now of two. The average over time is not even one. It’s around .9 all the way back to the 1960s, okay? So it’s double what it should be. It’s the highest it’s ever been.
That’s not a good sign when you have a valuation indicator that says it’s the highest it’s ever been. And so you’ve got to remember that each bear market, and bull market, and market in general has different characteristics. The late ’90s was a market cap bubble, meaning the biggest stuff was what was really expensive. The Ciscos of the world. Whereas now you have the entire market is just shifted up. The expensive stuff’s not terrible, but just everything is more expensive. As the Fed has pushed people into these risk assets. But again, this indicator would’ve said stocks were cheap in 2008, 2009. It would have said stocks were cheap in the early 1980s so you want the indicator to be right at the big inflection points, but there’s another one that doesn’t even use valuation. The anonymous blogger, Jesse Livermore, talks about this. What percentage of households have in U.S. stocks?
Again, you can take this back to the ’50s. It’s ranged as low as I believe the low 20% all the way up to the highs of 60% of their assets and stocks. And not surprisingly it looks exactly like a chart of the inverse for future U.S. stock returns, so it has a something like 90% correlation, which you couldn’t even design a stock indicator to have that high of a correlation. And so at the inflection points of the early ’80s, it was predicting double digit stock returns. What happened? Double digit stock returns. In 1999, it was predicting negative returns for stocks. What happened? Same deal. Right now it’s saying the same thing as CAPE but doesn’t even use valuation at all. It simply says how much do people have in stocks? It’s suggesting around a 4% return which is kind of astonishing because it doesn’t use valuation at all, simply how much of people put in stocks.
Jeff: It’s crazy, it’s that accurate without any sort of market data.
Meb: Well, we’ll check back in 10 years, see if it worked out. The podcast or holographic podcast at that point probably, and you can look back to times when, again not even looking at valuation but the best and worst starting points. So if you picked out the best starting points, you could’ve had a future 10 year real return of 16% a year. Add on inflation, that’s about 20%. But the flip side, the 10 worst starting points you would’ve lost about three percentage points a year. My mom famously says, she goes, “Meb,” growing up, she would say, “The way to invest is you buy stocks, you hold them, and that’s it.” Which is good advice in general, but it’s particularly good advice during most of her investing career, the wealth building phase which was in largely part the ’80s and ’90s. The biggest bull market we’ve ever seen.
But if you ask someone, for example a lot of our friends, a younger generation who started investing maybe in the late ’90s, early 2000s, say, “Why in God’s name would you ever invest in stocks? They’ve returned about 1% a year.” So it’s very time dependent on when you start. However, if you look at the 10 best starting points, totally independent, but the average CAPE value was 11 for those years, the 10 worst was a value of 23. So you can see that in general if you’re thinking about whether we’re at a secular bull market starting point, secular bear market, odds are we’re actually closer to the bear market side of things than the bull.
Jeff: I’ve heard you give, you know, bits of this speech before, and I’m used to hearing about Schiller as more of a buy signal I guess, than a sell signal. Just hey, it’s a great time to get in. But if you use it as a buy signal and you don’t want to wait until an extreme, you don’t want to lose your money, you don’t want to suffer the crash, would you and could you use Schiller as a sell signal to get out at an appropriate valuation and move to less risky assets? Something more price for performance at that point.
Meb: One of the things that people talk about efficient markets and you can’t time markets, which always drives me crazy, is that, okay let’s say, if you went back to the late ’90s and said, “All right, would any rational person pay 45 times earnings for the stock market?” The highest it had ever been before was in the ’30s. And using that model, we define a bubble as something where there’s no possible way… We’ve borrowed this from Cliff Asness. There’s no possible way a reasonable person would say, or a model would say that the future returns are going to be positive. So, yeah, so if you get a market that gets into, we see, you know, 30 is kind of a beginning of a yellow flashing light saying, you know, take a step back, so we’re not even there yet, but it’s about expectations at this point. Chances are we’re going to have about 4 or 5% returns, yellow flashing light. And then if you hit a value of 40, that is a full-on stop in my mind, red.
There is no reason to be owning those stocks. So if you look historically, you go back at returns and peaks, of bulls and bears, and secular, [inaudible 00:18:14] say we have a 15 year real return chart we’ll post to the blog, and you look at the peaks of when the best performance was ending. Of course the Schiller was 32, 22, 24, 44. Then you look at the bottoms, it was five, six, nine, seven, and ironically now, despite the fact we’ve had sub-par returns for the last 15 years, the CAPE Ratio is still elevated. And one of the reasons that people often defend, right now the CAPE’s allowed to be higher, is they say, “Well, inflation is tame. We have really low inflation, and inflation plays a part in future valuations, and what people are willing to pay for stocks,” and that is partly true. In this inflation, what we call safe zone, of 1 to 4%. People are willing to pay higher multiples for stocks.
So the Schiller CAPE Ratio bumps up from an average of 16, 17 up to around 20. Maybe even 21 at the very peak of this mountain top. However, the Schiller value also craters once you get above to about a 3% inflation, or 4% inflation, people are willing to pay much less for stocks, the future is much less certain. And certainly when you get up above 5%, and then 10%, they want to pay way less, and then the same thing is true also for deflation on the other side.
Jeff: Assuming reasonable inflation for a minute, how would you use Schiller to help you know whether or not the market is attractively priced? Because if you look back at the ’90s for instance, I believe Schiller would have had you out for much of that decade. You would’ve missed a lot of good returns, so where is really the line in the sand?
Meb: This is a topic that I think people often get wrong or misapply, so if you buy something, a stock, a stock market, a car, whatever, let’s say you paid an expensive price. Antique car, whatever it may be, a house, most people can relate to this. Back in the… Probably now, where we live in L.A., it’s going a little crazy again. And let’s say you buy a house for a million dollars. Someone comes along and pays one and a half million for that house, just because you bought an expensive asset and it went up, doesn’t mean it was a good bet. And you can think about this in terms of the casino too, how many people have you seen go in, put money on a number in roulette, and win? That’s not a good bet. You will lose all your money if you play that long enough, and the same thing applies with stocks. So let’s say you went back to the ’90s, and I often tell a buddy…
One of my blogger buddies uses this example a lot as a thing they hate about CAPE, and I say, “Look, yes, CAPE got expensive in the ’90s, I think it was mid, early ’90s. Let’s call it a value of around 20, 25, whatever it may be. And you would’ve been out of stocks since then, and that’s a good thing.” And they say, “What? You’re crazy? What are you talking about? You’ve missed 500% returns or whatever it is.” And I say, “Yeah, but like if you moved out of socks and simply put your money in bonds, 10 year U.S. bonds, you would’ve ended up in almost the same place. And you would’ve also have avoided two major bear markets and stocks that would’ve lost you half your money at some point, so behaviorally had you been able to sit through that, you would’ve been much happier in bonds.”
We’ll come back to this in a little bit, this topic, but simply because a market’s expensive and gets more expensive, doesn’t mean it’s a good reason to own it. And by definition, they have to, for the multiple to expand in the P/E it has to get to… For it to get to bubble territory, it has to appreciate. So we’ll come back to that in a minute. It’s a good question but we’ll come back in a minute.
Jeff: Not it’s challenging to sit by and not do anything while you see friends and neighbors making a hell of a lot of money. Even worse if maybe you are handling money for clients, and they all see people and putting pressure on you to take part in all those gains.
Meb: Well, sure. So you probably would’ve been fired long before you would’ve had the chance to say, “I told you so,” which is the big problem about that. But the beauty of this now is that it gives people, advisors, investors, something to anchor to. So whereas before you were watching CNBC, reading the journal, talking to your buddies, and saying , “Are stocks expensive?” or, “The Fed this or that,” and you really have no idea how to judge it. And by the way, listeners, you have to distinguish when you’re listening to the media. For example they’ll talk about P/E ratios. They may talk about trailing P/E ratios, forward estimated P/E ratios, which by the way work more poorly than the CAPE Ratio does. Or you may be talking about CAPE Ratio. And you have to compare it to the time frame that you’re measuring, and a lot of them have different average values. So a CAPE Ratio of 15 means something totally different than a one year P ratio of 15, and a forward expected of 15.
So you have to have a little perspective, and particularly also a lot of people will talk about valuation, and only take it back to say 1990. Well, that’s not a reasonable period because it encompasses a massive, the biggest bubble we’ve ever seen. So really you need more perspective, at least take it back to the ’50s, if not all the way back to 1900.
Jeff: I was just out of college, I was interning for a short period at Merrill Lynch, and this is just before the explosion. I guess it was, I mean ’98, or ’99, and I remember the guy I was working for used to say, he always used to use forward P/Es that were based upon these, you know, expected earnings that were massive. Especially in these tech companies. Yeah, I didn’t really know much about it, but I had enough of a sense to think that was potentially a little misleading. But he used to say, “This is the new economy. Everything you’ve known in the past is gone. This is all going to stick around. It won’t go anywhere. Tech is here to stay. The old brick and mortar companies are gone. You have to use forward P/E.
Meb: Eyeballs and clicks.
Jeff: And then it all erupted.
Meb: Yeah, the new eyeballs and clicks would be what? Drones and VR, self-driving cars, robots, who knows? All right, so we often say, “Look, this is a little depressing. Stocks are going to be 4%-ish. A lot of people don’t like to hear that. What about bonds? Well, bonds is the easiest asset class in the world to forecast, because the one point, what is it? Seven percent yield right now? That’s pretty much what you’re going to get over the next 10 years in treasuries. And so the returns are super easy to forecast, you say, all right, 1.7 % in bonds, and let’s round up and just be super nice, 5% in U.S. stocks. No combination of those two, even if you added them together, would get you to an 8% return, particularly that most pension funds expect. So, you have a very poor opportunity set. The good news is, like going to the casino, no one says that you have to bet. No one says that you have to play. We say stocks are expensive, bonds yield nothing. What can you do?
Well, we were the first to do this to my knowledge. We went and built CAPE Ratios for every country in the world, foreign developed and emerging. It’s about 45 countries. A lot of them don’t have history going all the way back to 1880 like the U.S. does, but many of developed world, you can get back to the ’70s. Some countries like U.K you could take back even farther. They add on every year more and more. A number of databases will take this back with other variables, but with CAPE, we can take it back pretty much to around 1980. And what we found is a couple things, one, in general stocks move together. Right? It’s a globalized world. It’s the same asset class, so they move up and down together. There’s a high correlation. It’s becoming more highly correlated overtime, but at time, you notice big differences in any given year, between some that are trading at really high valuations and some that are trading at really low ones.
There’s almost always a crisis going on and almost always a bubble going on. So if you look back to, say 2007, 2006, you may have remembered the acronym BRIC, Brazil, Russia, India, China, and people were hugely promoting those countries. They were the new growth engine. Well, China and India were trading in CAPE Ratios in the ’40s and ’60s. Why have they had terrible returns since then? That’s one of the main reasons. Those were both just pure bubbles. That’s nothing compared to the biggest bubble we’ve ever seen, which was of course Japan. The older listeners of this podcast could remember Japan in the ’80s. So japan was taking over the world. Every magazine article, every book was about the Japanese business model. They were buying up all sorts of U.S. real estate, I think the Rockefeller Center. There was talk of the land under the Imperial Palace, and Tokyo was worth more than the state of California. All these things you see during a bubble. And Japan has hit the highest level of any country in our data base, which was almost 100. I think it was 95 in the late 1980s.
And when people talk about the lost decades of Japan, and their poor demographics, and they’re uncompetitive, and their zombie banks, and low interest rates, and deflation, all this other stuff as reasons that stocks have done so poorly. Well, the main reason is they just had the biggest bubble we’ve ever seen, and it’s taking a long time to work off. And it’s not like Japan is some back water economy. This is the number two, I think now number three economy in the world after China. So there’s an entire generation of Japanese that will never invest in stocks because they know it’s a losing game.
Jeff: Is there a general equation you can use to point towards the work off period? From CAPE down to, you know, back to normal levels?
Meb: Well, so if you have, for example if you line up the bubbles of U.S. and Japan, it’s funny because it makes the U.S. bubble look just minute in comparison. Almost cute, it just looks tiny. This is how big the Japanese bubble was. And if you weren’t sitting through this it would be, it’s hard to relate. The size of the bubble relates to how long it takes to work off. Of course if you had a massive crash, it makes it shorter, like bitcoin went through but is probably now and back into an uptrend. The U.S. basically took, from 2000 to 2009, 9 years to work off, because the bubble was large but not any of the largest we’ve seen. Japan took 20 years to work off, and by the time that it finally got cheap, no one cared anymore. So maybe it was three, four years ago Japan got super cheap. But try telling someone to buy Japanese stocks, they would’ve said, “You’re crazy.” For many reasons.
Then of course what happened, Japan was the best performing stock market in the world a few years ago, rinse, repeat. It happens over and over again, so if you look at foreign countries and CAPE Ratios, you find it works just the same as it does in the U.S. You buy the cheap stuff, it has the best performance. You buy the most expensive stuff, it has the worst performance. The good news is foreign developed is trading at a pretty reasonable valuation. Foreign emerging is super cheap. It’s in the low teens right now so those are much higher expected returns. High single digits, real returns compared to the U.S. which is low single digits. And then if you went back, and we talk about this in our book, “Global Value,” and you sorted countries by valuation, and you invested in the cheapest 25% of countries versus the most expensive 25%, it’s no surprise but that outperforms buy and hold by quite a bit.
And obviously the worst thing you could do is invest in the expensive stuff that under performs buy and hold of the countries. And we often say this to people, is that it’s not just about buying the cheap stuff, it’s also about avoiding the most expensive. So a value approach is not just about buying the cheap countries but avoiding the China’s and India’s in 2006, ’07, ’08, as well as Japan during the entire 1990s and 2000s.
Jeff: Where are we at right now with country from yesterday’s news, Greece?
Meb: Okay, I’m going to hold off on that for about one minute. We’ll come back to this in a second when we talked about all the countries in general. We can even go to it now. So, if you look at where the world looks right now, U.S. is 25, foreign developed, let’s call it I think 16, 17. Foreign emerging, maybe 13-ish. The cheapest bucket of countries is around 9, which is one of the lowest we’ve ever seen, going back to certainly ’08, ’09 as well as the early 1980s. The cheapest country in the world, you want to guess?
Meb: Well, Argentina is technically a frontier market, although we used to look at that one. We used to calculate it. It’s guaranteed to be low. They’ve been having monster returns. I was reading over breakfast this morning that I think Zulauf was saying that he expected the Argentine peso to be the best investment over the next 12 months. So I’m assuming they’re low. I’ll follow up. We’ll post it on the blog. I imagine they’re low single digits, I’ll give you one more guess, then I’ll just tell everyone the answer.
Jeff: Go for it.
Meb: All right, Russia is currently our number one. We did an article in January talking about the cheapest country in the world in global valuations. We’ll link to it in the show notes, and at that time it was Brazil. One of the things that we do in our, so the CAPE, I’ll read off a few. Russia’s at five.
Jeff: I thought Russia had been rising recently?
Meb: Yeah, but they’ve also, they’ve round tripped a little bit. They’ve come back down, so Russia’s at 5, Brazil’s at 8, Poland 9, Czech Republic 9, turkey 10, Egypt 10, Hungary, Portugal, and Spain, all about 11. And there’s about 10 more around 11 and 12. That list that I just read, if you’re listening to this over lunch or right after lunch, I apologize because this is one of the reasons that this strategy works, or value investing works. No one wants to get off this podcast, call up their broker, pull up E-Trade, and buy Russia, and Brazil, and Egypt, and Turkey. News flow there is terrible, and it’s a little better now than it was say a year ago. I mean Brazil is going through, essentially getting through a great depression. They have Zika going on. They lost, they just got knocked out of COPA tournament, which is great because we have the quarter finals coming up with the U.S. All of the news flow is bad.
Russia, it’s bad but it’s not as bad as it was few years ago when they were shooting down commercial planes, invading countries, oil was getting hammered, all the bad things. But the name’s changed, so you always, on the cheap side, you almost always have terrible news flow.
Jeff: So practically speaking though, what do you do? Just hold your nose and do it regardless? Or is there ever a time in which you’re tempted to say this time it is different?
Meb: So the approach we recommend is buying a basket of the cheapest countries. So let’s call it the quartile, 25%, so out of 45 countries, we have a fund that does this. It goes and buys the 11 or 12 cheapest countries. So you diversify. You never just put all you money in Russia or Brazil because things can always get worse. If you look at a chart of countries and the P/E ratios versus their current drawdown, meaning how much is that stock market down? You find a very high correlation because the P in the P/E ratio is the price, so when the price of a country or stock market has gone down, 50, 60, 80%, it makes the P/E ratio usually really cheap because simply the price has gone down. And so investing in these cheap countries means you’re often buying basket of stuff that’s down 50 to 90%.
There’s a famous investing joke that goes, what do you call something down 90%? That’s something that was down 80% and then gets cut in half again. So the mathematics of markets that are declining can be really challenging for people. And it can still be really painful, so as an example, if you bought, say Czech Republic right now at a CAPE of 10, to get to a Russia valuation, what would have to happen? It would have to go down 50%, and so this happens. But when you buy a basket in general that’s worked out great over time, not just that and there’s another great quote. I think it’s from Mark Yusco, we’ll have him on the show one of these days, where he says, “Investing is the only business when things go on sale, everyone runs out of the store.” And so if you sort country stock markets by coincident indicators, like trailing GDP, trailing currency returns, you could even sort them by corruption index, I’ve seen this, but a number of these things that you would expect, you would want to see all sunshine and roses, it’s actually the opposite.
You want to be investing in the places that have the worst GDP. The worst currency returns, because they get pushed too far. At some point you have to be able to distance, you know, is this basket too cheap? So on the flip side, we have countries that are all hitting new highs. The U.S. is at 25. There’s only two more expensive currently, Ireland and Denmark. Denmark’s a little funky because it’s got a large chunk of the index and a few stocks, one health care stock in particular. Japan’s up there. Mexico, Philippines, and Switzerland are all above 20. But again, none of those valuations are terrible. Those are fairly reasonable. I’ve been giving this speech a few years, and I often tell this story. I said I’ve given it in Mexico City, I’ve given it in Bogota, and in both cases, I gave the speech when Mexico and Columbia were trading in CAPE Ratios I believe in the ’30s, Columbia may have even been in the ’40s. And I said to the audience, it’s was an institutional audience managing a gazillion dollars. I said, “Look this is a great country. I love the people, the food is great. It’s beautiful. Everything about it, awesome, but just FYI, your stock market is one of the most expensive in the world. Historically that means the odds are not in your favor,” and of course I was very unpopular.
And so in the breakout, these guys that were managing literally just billions of dollars, they said, “Meb, you don’t understand, every month pension funds put 10 billion into the stock market,” whatever the number was. I don’t remember. “Put all this money in the stock market, and its constant. Oil is at 100 bucks, we’re making a ton of money here. This is never going to go down because we have a constant flow.” Well, of course, what happens? The Geo political environment changes, the economy changes, oil’s now at 50 bucks or whatever it is, and Columbia has had a major drawdown. They’re actually ironically back to a reasonable valuation, so if you’re the conference organizer from Bogota, I’m listening. I want to come back and give you a great message which is Columbia is at 15 and probably a great buy.
Jeff: Well, you got a great story though about the other end of that extreme as well. Weren’t you speaking over in, was it Eastern Europe?
Meb: Yeah, Eastern Europe last summer, and I said, “Finally, you know, I’m going to be the most popular guy here. I’m going to tell you a wonderful message which is your stock markets are cheap,” and I gave this speech, and kinda got this slide, and kinda was smiling, waiting for the applause and…
Jeff: Thunderous applause.
Meb: People would buy me drinks after. They bought me drinks after anyway but no one cared. Because at that point, you know, you have massive unemployment. The economy is doing poorly. Anyone that had money has probably lost 50%, 80%. You know, if you’re a Greek right now, you’re not jumping for joy that your stock market’s cheap because chances are you’ve already gone through, your essentially your depression, and very difficult to have dry powder on the sidelines. You know, much like being an American in the U.S. during the Great Depression, there’s not…the general sentiment is not one of jumping for joy that the stock markets cheap. It’s that everyone’s unemployed and times are tough. There’s a great story though, as an aside about, we wrote this on the blog a long time ago, called “Doing a Templeton,” where Sir John Templeton went out and bought every stock on the NYC I believe that traded below $2 or something.
So he just bought this huge basket, and you know, many of them went to zero, but he ended up making huge returns because a lot of those multiplied in the years since. We actually wrote this article after 2009. We should probably follow up, see how it did. Anyway, so you have the challenge of this. And when we publish this and give it as a speech, there’s two columns. The left column is the cheap stuff, the right column is the expensive stuff. And we often joke that the left column is called “Career Risk,” because if you’re an advisor and you call up an investor, and you say, “All right, we’re going to go buy these stocks in turkey, Egypt, Poland, Brazil, Russia, and they continue to go down, you get fired. You may last a year or two. If they do great, okay, you may get a pat on the back, but it’s not worth that risk, so it’s a consistent headline risk that’s not worth it for most people.
However, when things get to extremes like they are much of Eastern Europe in Europe and places like Russia and Brazil, we did a study in our book that showed what our future returns look like when things get down to what we call “blood in the streets.” And future 1, 3, and 5 year returns when CAPE goes below 7 over 20% a year, so big returns. Then on the flip side when you buy something in a true bubble, so over a CAPE valuation of 45, what the U.S. hit in the late ’90s, you have negative returns. It’s not saying there’s no possible way, but in general the odds are against you. In a cool study that PIMCO and Research Affiliates just put out recently, they did a similar one, they said, what is five year performance when all these country’s Schiller CAPEs go below a value of 10? And they found very similar returns which was an average 5 year performance of 120%.
Jeff: So I’m listening to this, trying to figure out how the best way I can apply this in my own account. And for any investors listening who are thinking similarly, is there a line in the sand you’re willing to get behind that sort of access to green light? Is it 10, 8, 7, or is it so…
Meb: You know, the way we view it, it’s like a spectrum. It’s like a probabilistic spectrum, where let’s say it’s trading at a valuation of a normal valuation 16, 17, even up to 20 in a mild inflationary environment. We expect normal returns, so historically real returns in the U.S. have been six and a half percent a year, back to 1900. Add on a couple percentage points inflation, that’s a 10% return, that’s great. And the more that it goes down, the valuation, the more that it goes down, which you should cheer for if you’re young and/or a saver. If you’re older, that’s a little tougher, but as the valuation goes down, stocks get more and more attractive, Buffet talks a lot about this, so when it gets down to the valuations in the single digits, I think you’re looking forward to double digit returns. And the flip side happens as things go up, so it’s not like where there’s a specific number. You know, as I mentioned earlier, on the upside, you know, 30 seems like a yellow warning light to me. But really anything below that I think is fine, it’s just you have to have your expectations. A different way of sort of framing, I think that looking at this is a couple things. One is that we live in a global world, and foreign stock returns versus the U.S. is a coin flip.
So if you go back as far as you want, foreign stocks outperform and under-perform U.S. stocks on a yearly basis, it’s literally 50-50. But, and this is the challenge with any strategy, is that they go through many years of regimes where there’s 2 periods since 1972 where foreign stocks have outperformed U.S. stocks for 6 years in a row. Not a six year period, six years in a row. And these go through the periods where everyone is rushing into foreign stocks, and they can’t wait to get invested in Brazil, and Japan, or China, whatever it may be, but that also happens on the flip side. And so right now we’re in one of those periods where the U.S. has been crushing it since the global financial crisis, but most of these foreign markets have really lagged. And so you’ve seen emerging markets be down three years in row.
So all of these coincident indicators, cheap valuation, nobody wants emerging market stocks, at least no one that I talk to. We think it’s a great time for it.
Jeff: Explain to me, if we’re at 25 right now, sort of backing up from Schiller, if we’re at 25, which is high but it’s not bubble. You said your yellow light starts at 30, so we’re still not even at yellow yet. Why is there so much pessimism? I mean the other day you were talking about that one sentiment indicator which is extremely bear-ish right now, what’s the issue?
Meb: I think part of that is if you look at the environment since ’08 and if someone also had been investing in 2000, there’s a lot of trauma involved with bear markets. I think most advisors and investors don’t put enough importance on the actual, literal physical pain of losing money and going through those bear markets. And so often portfolios while the mathematics would say you should have all your money in stocks, that’s usually not the best portfolio because people have to live through those times and often behave very poorly afterwards. And so when you have things when, you know, right now where you’ve had this seven year, eight year bull market in U.S. stocks since the financial crisis, and I think people have a general understanding that stocks are expensive. But they don’t know what else to do, and so they look around and they say, “Bonds yield nothing, real estate’s gone bananas again. I don’t know what to do with my money,” and so people end up doing crazier and crazier things.
We’ll talk about bitcoin in another episode probably, but, you know, so they get pushed into…more out to the spectrum of risk type of assets, and it has a lot of unintended consequences. We talked a lot about how dividends are our least favorite asset class because so much money has flown into dividend stocks, completely changing the characteristics of high yielders to now being one of the most expensive asset classes out there. Again, we’ll save for probably another podcast. We’re getting a little off topic here. But in general I think that the sentiment is people are just nervous and they don’t really know what to do.
Jeff: Okay, all right, so if we’re sort of running on a little bit, let me try to boil everything down here. What does all of this really mean for the average investor? You know, how do you distill it down?
Meb: There’s a few levels of steps, okay? An increasing level, or decreasing level of importance. So the first one is the most important. When I asked you that question earlier and said, “What percentage of your stock allocation do you have in the U.S.?” You said 90, 95. Every time I’ve given that speech, the average is right around 70. I think it’s been as low as 65 and as high as, it’s been in the high ’80s, I think maybe even 90 before, but it’s almost always around 70. And that’s what we call home country bias, meaning if you look at the global market cap portfolio of all stocks around the world, the Vanguard definition of the global index, only half is in the U.S. and the other half is in the rest of the world. And this usually surprises people. They think that the U.S. is the biggest economy, which it is, the biggest stock market, which it is. But it’s only about half, so by definition, you should start out with half in the U.S. but no one ever does.
One of the reasons is because it feels comfortable to have U.S. assets. It’s what you know. People use Google, they may, you know, use IBM, whatever the products are, Apple, they’re familiar with, but it’s usually a very terrible thing to do. You know, the same reason I’m a Broncos fan, you’re a Tar Heels fan is that’s the home bias, but it happens everywhere. It happens in Italy. It happens in the U.K. Some of the worst offenders are in Asia. They put the most in their own markets. It’s even more insidious in those countries because while they may put 70% in their own country or region, their markets are even much smaller. So they may only be 5% of world market cap but they put 70% in Italy.
And in general that concentration, while it can work out, is usually a pretty bad idea. One of the things we talk a lot about, so that’s the market cap portfolio. In market cap, investing is really problematic, and this is a perfect time, perfect example because the U.S. is the most expensive country in the world. What are you putting most of the assets in a global portfolio in? The U.S. So a value investor, and you could implement this through any sort of value fund, whether it’s global value fund, foreign value fund, starts to tilt you away from this market cap portfolio. There’s a great chart from Ned Davis that shows U.S. stock market going back to, whatever, the ’70s, and had you invested in the largest company in the U.S. stock market at the time, how would that have performed?
And it would have been a terrible strategy, so, you know, Apple was recently the largest. Now I think it’s Google Alphabet, but familiar names. Probably what are some of the big ones? Exxon, I think Cisco was in there, GE, IBM, Microsoft. Research Affiliates have done some research where they show that the average…the largest market cap company in the U.S. is under-performed by about three percentage points a year. And this also applies to every sector. The largest stock in each sector under performs by about three percentage points a year. One of the reasons why is it’s simply capitalism. You know, the creative destruction of the markets. People look at the iPhone and they say, “Wow. You’re making billions of dollars off this really cool product. Why don’t we do that too?” and so they chip away and you have this… And that’s the beauty of the system, but market cap waiting, it is the market. It is the definition of the market. But if aliens came down to earth or someone said, “Hey, I’m going to design an ideal investing process,” no one would ever say, “Let’s just invest based on size.”
Which is simply price times the number of shares outstanding. It literally makes no sense. In no other field do people say, “Let’s just invest basketball maybe, by the tallest.” But nowhere else do you say, “Let’s just invest by the biggest.” It doesn’t take into account revenues. It doesn’t take into account valuations. So an investing approach for example that uses valuation, is a much better idea than just market cap alone.
Jeff: Okay. So one take away then is get away from market cap, and the other take away, you were saying, is expand from your domestic investments. One question on that though that I wonder about is, do you face any currency risk if you’re going through a much global investment set?
Meb: Okay, so three comments first. So first start out with a global portfolio. That’s 50% U.S., 50% foreign. Most people have 70%, so they’re making a very active bet on the U.S. whether they like it or not. But at least be aware you’re putting a lot more in the U.S. for better or worse. It happens to be one of the most expensive countries, so we think that a minimum of 50% foreign, and then on top of that you can tilt towards value. Now that’s going to put you in a lot of places you’re not comfortable with, but that’s what I think you want to be doing. So those are in order, the last being if you really want strong returns, I think you want to concentrate in the cheapest countries. Currencies are interesting topic because there’s a famous quote, not so famous. There’s a popular quote that I like to reference called, it goes by an FX author, it says, “Currencies aren’t difficult, they’re just confusing.” And so real currency returns are actually stable overtime. Meaning currencies across borders adjust for inflation. So hypothetically, let’s say we had zero % inflation in the U.S. and Russia has 10% inflation, well their currency should decline in the next year by 10%.
And the returns are still then equal. Real currency returns are equal in that case, and that’s the way that it should work because inflation that works across borders. And most people don’t realize that. However, currency returns are notoriously volatile, so, you know, you’ve seen with the yen, you’ve seen with the Canadian loonie, a lot of things in the last few years with these 10, 20, 30% moves, right? Thinking about currencies, we think it makes sense or not, to hedge them, I don’t care, I’m agnostic. But whichever one you pick, you have to stick with it. So if you decide to hedge all your currency returns, great, do it. But you can’t flip back after, you know, the dollar has a five year bear market or bull market, and then flip because you’re probably going to do the wrong thing.
Jeff: But if you don’t want to mess with it and you have a long return horizon, you’re okay?
Meb: It doesn’t make a difference. Now it’s a little different with developed market sovereign bonds because the currencies are introducing volatility to an asset class that isn’t very volatile. Think of U.S. treasuries, not that volatile, right? So on top of that adding currencies volatility to a low vole asset class, and we’re going down a rabbit hole here. I think it makes sense there, but in general, sort of [inaudible 00:51:09] now a totally separate conversation for a different podcast would be our currency returns, can you develop factors like value in the U.S. that apply to currencies as well? And we think you can. But that’s a different question. That is are you making an active bet on currencies? And there’s some simple strategies like value people call purchasing power parody, which is very similar to the Big Mac index that people talk about. How much is a Big Mac in the U.S.? How much is it in Europe? Then there’s trend following and interest rates, what a lot of people call carry. All those work, but again you’re making active bets, and they’re going to start to look a lot different.
May not be intended bets for what you’re looking for.
Jeff: Save that for later.
Meb: And another question that people often, a very similar one is that well the U.S. gets X percentage. I think it’s, you know, 40, 60% of sales from abroad which makes sense because the rest of the world, the U.S. is only a third of the world GDP, which is another reason to love emerging markets by the way, because emerging markets have roughly the same GDP as the U.S. one quarter of the market cap and 10 times the population. So if you wanted to make a bet over the next 50 years, what would you prefer to bet on? Also they have half the valuation of the stock market. But people often say, “Well, did you get sales from foreign markets?” To which my response is, “You don’t think foreign markets sell into the U.S.? It’s the largest economy in the world,” so obviously there’s some cross over. And if that’s the case, if you live in a world that’s very interconnected, then valuation makes even more of a difference. You should be country agnostic, border agnostic, find the places where valuations are cheapest. And so this brings us back to when we were talking earlier about, “Hey, when stocks were expensive in the ’90s, you know, had you been out of stocks?”
I say that would’ve been a great thing, but you don’t live in a world of just U.S. stocks or U.S. bonds, that’s the choice. You could’ve also said, instead of U.S. stocks or bonds, I’m going to invest in the cheapest countries in the world, and that would’ve been a vastly better choice than just the U.S. opportunity set. We often say there’s no limiting factor to what you can invest in. You can do baseball cards, comic books, classic cars, put your money under the mattress, but there’s no reason to just be limited to U.S. stocks and bonds. So I’m going to kinda wind down here unless you have any more questions on this topic?
Jeff: Well, I’ll kinda put you on the spot. One last question for investors, top three countries you would look at right now?
Meb: Again, with the caveat that you should be buying a basket, the three cheapest, Russia, no question is super cheap, Brazil as well. You know, Greece. You asked me about Greece earlier, Greece is interesting because, and this is an example of something where you always should measure what you’re investing in, or invest in what you’re measuring. It works both ways. Greece is one of the smallest stock markets in the developed and emerging marketing universe. Applying the CAPE Ratio, you need to be very careful on exactly which index you’re looking at. So MSCI calculates a few different variants of this index, and this is also one reason we don’t just use one variable like CAPE is that depending on which index you look at, Greece has a CAPE Ratio of either 2 or like 70. The way we’ve always run our funds and strategy, we say, “All right, we’re not just in it for the wonks out there.” This is the MSCI investable market indexes and regular market indexes.
We’re not going to go down there right now, but this is why we use multiple valuation indicators. So we calculate 10 year cyclically adjusted, not just P/E ratios but dividends, cash flow, and book. And so now on CAPE, Greece may be ranking a high valuation on earnings, it’s still really cheap on the other ones. So it still ends up in the cheap bucket despite one factor being wonky. So I would still invest in Greece. It’s even more timely now because it seems to be entering an uptrend. And on top of that, what was it, Hillary Clinton’s son in law just shut down his Greek hedge fund because it was down like 80%. So you see these coincident indicators that make you happy to be investing in countries like this, kind of the worst places in the world basically is where I want to be investing. Russia, Brazil, Greece, and almost all of Eastern Europe as well.
Jeff: Fair enough.
Meb: So we’re going to wind it down. As in every episode, we’re going to ask a question and we’re going to force Jeff into doing this as well. What do you find useful, beautiful, or down right magical? And we’ve had some interesting responses so far. I’ve had my original was Dashlane, and then Patrick came on and suggested an axe of all things. Jeff, you have something for us?
Jeff: Something I have to do a lot in, you know, my job here is a lot of researching. And download various reports, and looking into all sorts of data information. And a lot of it requires email addresses. They want to capture data on you, but I’m not always wanting to give out my email address. So a site I’ve used several times is fakemailgenerator.com which actually will spit you out a fake email address which you can put into whatever site you’re at, and any mail that goes to that email address will immediately go to you at that site. So you never have to break out any email addresses or anything. You’ll get whatever they’re sending hassle free.
Meb: That sounds incredibly shady. All right well, to those hiding out in Chile from the U.S. government, there you go. Mine is a site called Wirecutter. And this is a site that you can go to if… Older folks may remember CNET, you know, people probably still use that, I have no idea. But let’s say I go online, I want to buy the best fan, or you know what? I don’t want to go spend 20 hours of research researching a TV, which by the way there’s a great TIAA-CREF study that talked about people will spend more time researching TV than focusing on their retirement investing assets. I don’t want to spend time on this, I just want someone to tell me, “Look, what’s a consensus best reviewed? What’s the best deal? Where can I buy it? Just tell me what to do.” and Wirecutter does this for…they started out with electronics, they do a composite reading of all the reviews from different sites. But then they go and test them all themselves, and then the way they make money is of course through affiliate links. So they’re unbiased because they’ll get paid no matter what, which one they recommend.
But, you know, you click through, they’ll get an Amazon affiliate link or whatnot. But it has saved me vast amount of hours through buying a lot of just, I mean even things like a surge protector or the best kitchen knives or whatever it may be, anyway…
Jeff: It covers that many things?
Meb: It covers…because they have a home version too, so the original was just for electronics. They’ve expanded into all sorts of different stuff. Now the bad news is you’ll probably go on there and end up spending a bunch of money, but it also is a big time saver as well. So that’s a great one.
All right, we’re going to wind down here, episode three. As usual, we’ll post the show notes online to mebfaber.com/podcast, including some of these charts. You can find more information, follow me on Twitter at mebfaber.com, our research site, The Idea Farm, and of course my work addresses, cambriafunds.com and cambriainvestments.com. Until next time, thanks for listening and good investing.