Our Man’s performance last
year was disappointing, and one of the major sources of the disappointment
stemmed from failing to capture some profits when positions moved significantly
in OM’s favour before later reversing.
This was particularly the case with some long-term positions, such as
EUO,
which went was being a positive 50bps+ contributor to one that cost the
portfolio over 30bps on the year. Thus
one of Our Man’s aims for 2013 is to show greater flexibility around his longer-term
positions, especially by using technicals more to help with when to resize
positions by taking profits or adding to positions.
Those who read this blog
regularly know that Our Man likes discussing the CAPE, or the
Cyclically-Adjusted PE (it’s can also be known as the ‘Shiller PE’), ratio quite
a lot (such as way back when). While the
ratio is not very good at telling you what will happen with markets in the
short or even medium term, it’s very helpful as a long-term guide to value or
anchor. Over the last couple of years,
there has also been some great work and research done on CAPE’s globally and
also using empirical data to test whether the ratio does indeed prove a good
guide to long-term value. The most
interesting (and easily understood) stuff comes from Mebane Faber (Cambria Investments); and this recent paper provides a short and simple read that you
don’t need to be an egg-head to understand. Among the things that Faber’s work (and
others) empirically shows is that when CAPE’s are low (i.e. the market is
cheap) expected future returns are typically higher (especially over longer
time periods, 5-10yrs. See Figs 3A &
3B on page 5). This also holds true
outside of the US, where Faber looked at CAPE’s and returns for 32 markets (Fig
7 on page 10).
Why bring this up now? Well, the crisis in Europe has seen markets
fall and looking at the CAPEs, some are starting to reach valuations that are
very attractive both absolutely and relative to the respective country’s
history. While getting good data outside
the US is difficult (or expensive) for an individual investor, data back to the
mid-90’s is very easily accessible and Our Man used it to create his own CAPE
mini-database to get a sense of the valuations in Europe. (NB. You
may notice that Spain is a glaring omission from the below. Rather oddly, OM has misplaced his Spanish
data…)
What should be reasonably clear
is that valuations are clearly cheaper today than at any time in the last
7-10yrs in almost all of the countries.
While the US’ longer data set (see first graph in this post) suggests
that the last 7-10yrs have not been particularly cheap in a historical context,
it’s noticeably that in Italy (CAPE of just over 8) and especially Greece (CAPE
of c2) valuations are at an attractive level on an absolute basis.
Given these valuations and the
longer-term nature of CAPEs, it makes sense that OM is going to try and apply
some of the aforementioned flexibility by using technicals to help him get into
and size positions driven by CAPE valuations.
Interestingly, both Greece
and Italy
appear to have formed potential bottoms during 2012. While it’s not clear that the long-term pain
in those economies and markets is over, it seems to make an interesting entry
point.
Given that CAPEs are a good
guide to long-term valuation and Faber’s work which suggests the benefits are
better felt through long-term holdings (i.e. 5yrs+), you should expect to see
EWI and GREK in the portfolio for some time though their size will vary. While the positions have been started in
Italy (EWI)
and Greece (GREK),
given the sharper run-up in GREK since the summer, the position there is
smaller (c1%) with Our Man looking to add to it if there’s a pull-back of note.
As a final note, neither EWI nor
GREK hedge their currency exposure hence both would fall if the indices they
track were flat (or rose), but the Euro weakened (more). As such, at some point, Our Man may add some
EUO as a short-term hedge specifically against these positions.
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