My discovery of Crestmont Research and their work on secular investing led me to develop a dynamic asset allocation approach using valuation. I have also discovered that valuation can be used effectively for allocating to international stocks. The following paragraphs illustrate an optimal approach for international stock investing at the country level.
For US stocks we have the cyclically adjusted price to earnings ratio (CAPE) to measure valuation.
CAPE data is available for international countries through Global Financial Data and some including Meb Faber have started utilizing CAPE to manage his own international stock ETF, Cambria Global Value (GVAL).
Here is his paper on using CAPE globally:
Global Value Building Trading Models with the 10 Year CAPE
We can also measure stock valuation using Market Cap/GDP.
This chart gives an idea as to the correlation between Market Cap/GDP and CAPE for US stocks.
Source: The World Bank, Shiller
This begs the question: which set of data do you trust more when it comes to international stocks, earnings or GDP?
I prefer GDP data simply because I am not as skeptical of GDP data (China is an exception) internationally as I am the accounting standards in emerging market countries.
The following paragraphs illustrate a Market Cap/GDP/Volatility approach.
At the end we’ll develop an example of an optimal allocation across developed and emerging countries.
iShares MSCI ETFs were utilized for monthly country returns.
Only ETFs with the greatest history were utilized.
These ETFs cover a majority of countries which make-up the MSCI EAFE index.
EAFE countries missing: Denmark, Finland, Ireland, Israel, New Zealand, Norway, Portugal.
The source of the annual Market Cap/GDP data was the World Bank. Period: 1996-2012.
Benjamin Graham first proposed the “margin of safety” investing principle in his book “Security Analysis.” The idea is to focus on buying cheap high quality stocks. This same concept can be applied at the country level by first focusing on countries with low Market Cap/GDP ratios.
