When CAPE Fails

NOTE: Almost 3 months between posts! Not a great job with attempting to write with any sort of regularity. To be fair, I’ve been quite busy with a fair amount of other projects, ranging from the day job to financial-adjacent to Novatero-specific. I keep saying it (because hopefully one day it will be true), but big things are on the way for Novatero!

I respect Robert Shiller.

Correction: I respect the hell out of Robert Shiller. The man is one of the titans of economic theory, a recipient of the Nobel Memorial Prize in Economic Sciences, and has a very real possibility of getting another one if the committee gets its collective heads out of its butts regarding his work on Narrative Economics.

His Nobel was earned on the back of his work on the Cyclically Adjusted Price-to-Earnings ratio, commonly initialized to CAPE. The CAPE ratio is the “current price of a stock by its average inflation-adjusted earnings over the last 10 years”…in other words, it is a reflection of the gap between a company’s stock price and the income it is actually driving into its itself, adjusted for the market rate. Shiller found a very tangible, very strong relationship between the CAPE ratio and the following decade-plus of returns. High CAPE equities/indices/markets tend to see lower returns for the following decade, while low CAPE assets tend to see higher returns.

My goodness, just look at it. It's beautiful.

While Shiller focused mainly on the US equity market, the CAPE ratio has shown its applicability in other markets. Meb Faber of Cambria Investments amongst others has extended CAPE to other developed and developing markets, providing a inter-country cross-section of CAPEs for those wanting to avoid high-CAPE countries while capitalizing on their low-CAPE brethren.

I’ll also admit it: our Global Anomalous Index Allocation (GAIA) fund, currently building out its track record, was heavily influenced by CAPE…and by “heavily influenced” I mean “yeah ok it’s CAPE but with additional factors and also made to be much more actionable as an investment strategy by shortening up the return window”. Is Malaysia sitting at the low end in GAIA? Pick up Malaysian stocks or a Malaysian ETF! Is Finland too high in GAIA? Avoid it, or if you’re feeling adventurous, short it! I am a very big fan of the George Box quotation “All models are wrong, some models are useful.” The CAPE ratio is one of the most useful models of future return that I’ve seen, and could be one of the best answers of the “what” in the global equity market.

However, it’s biggest flaw through no fault of its own is that, like any model constructed solely from quantitative input, it cannot answer the “why”.

You would have to be living in a cave or well off the beaten path to have not come across news of the Russian invasion into Ukraine this past week. In lieu of sending troops or physical fighting support, the EU, UK, and US amongst others have sent help in the form of economic sanctions (the severity and scope of which are very much up for debate)*. These sanctions took a bite out of the Russian stock market, despite no immediate effects on any companies within the market. Traders sent it spiraling downward because of future value: the expectation that sanctions will make owning the asset now less valuable do to expected negative effects on future pricing. If you’re expecting a 20% return on the market over your investment horizon and these sanctions change your calculus to an expected 2% for instance, you’re going to cut and run to another alternative.

Effectively, these sanctions are placing a very heavy thumb on the scale for the Russian stock market…and also Russia’s CAPE ratio. Russia’s CAPE ratio has been consistently hovering around or below 10 for years now, and these sanctions should see it drop even further than the 10.53 from the end of Q4 2021. Typically, anything below 10 for this long is past-due for high annual returns for the next decade or so. The more feckless corners of FinTwit (Financial Twitter; think the Mos Eisley cantina but with absolutely laughable lack of diversity and a shitload of fleece vests) have been pushing the “BUY” button for the Russian stock market due to these sanctions. Valuations, CAPE or others, are so low! The market is so cheap! If you don’t buy in now you’re such an idiot!

First of all, a position in the Russian market only pays off if and when those sanctions are lifted. That means you’re essentially operation akin to Mark Spitznagel’s “doomsday investing” strategy where you’re taking a small, evergreen position on an unlikely scenario that will pay out incredibly well when the time is right. Except that Spitznagel capitalizes on a miscalculation of the probability of a large drawdown in markets with most of the position long in the market itself and a tiny portion going to OTM Puts, and “investing in Russia” is speculating that, at some currently-unknowable date in the future, sanctions will be lifted and the Russian market will take off like a Soyuz spacecraft. One is meticulously calculated and thought out, the other is placing your stack of chips on 00 at the roulette wheel. Even if sanctions are lifted, it’s not as though the Russian market is really good to begin with. Even Meb Faber, he of the global CAPE ratios, doesn’t trust the purported opportunity that Russia’s low CAPE should provide in the future. CAPE doesn’t adjust for sanctions, or feckless business practices, or purposefully shoddy bookkeeping. Sure, you could supplement the level-based CAPE with a trend-based measure that provides an expected range and oscillation of CAPE for each country (in fact, we rely on trend-based factors for GAIA!). But, again, sanctions place a heavy thumb on that measure. Is it worth it to hold a risky asset in the hopes that at some point in the future the shackles will be released and that it could maybe, possibly outpace the other 100+ countries with equity markets? Nyet.

Truth be told: I really shouldn’t be writing about the Russian stock market during its unjustifiable invasion of a sovereign nation. Financial blogging doesn’t hold a candle to the very real tragedy that millions of Ukrainians and their loved ones are dealing with as their nation and identity is trying to be squashed by a sad, angry, scared little man with delusions of grandeur and toxic nostalgia of a time long-passed if it ever existed at all. But I’ve been mulling this around in my head since I made the mistake of plumbing the depths of Twitter during the initial strike in the hopes of finding some existential salve for my fraying mind. An empathetic person should know how wrong it would be to consider investment strategies that capitalize off of the back of war.

I’ll let you in on a little inside baseball: right now our GAIA Light track record is in two countries: Malaysia and Argentina. Two countries far removed from eastern Europe and the war happening there. But beyond that, we make it a point to opt-out of any country in conflict if GAIA suggests it. Does this mean that GAIA will take a hit to its return by forgoing said country for the “next one up”? Possibly. But we as investors have a responsibility as human beings to avoid capitalizing on such clear and present events. Investing may be commonly referred to as a zero-sum game, but I refuse to let humanity become the same.

* Well dang, I just saw the news that they’ve voted to kick some Russian banks off of SWIFT. I haven’t seen the details of it, but that’ll have some sharp teeth if the power that be didn’t sand them down in the details.