Index investing is built on the idea that beating the market consistently over time through skill alone, is exceptionally difficult, or perhaps even impossible. Therefore, you might as well own the market as cheaply as you possibly can, using an index tracker or an ETF. This not only avoids the risk of drastically underperforming the underlying market, but it also gives you a ready-made diversified portfolio, which means that you avoid taking individual company risk.
However, while owning an index tracker can help you to minimise the risk of underperforming any given market, you then have the further question of asset allocation to consider. For example, you might put half of your money in the US stock market, given that it is the biggest, most important market in the world. Choose the right tracker, and you know that you should get the same return as the S&P 500, less costs.
But what if the US goes through a weak patch? What if another market - Japan say - outperforms it? You can overcome this by building a global index portfolio - using a very broadly diversified global stock market index (such as the MSCI All Country World Index, which offers stocks from across developed and emerging markets) and balancing it with a global bond index tracker. In effect, you are owning a representative sample of key assets around the world at that point. That’s a truly diversified portfolio, tracking a global benchmark.
An option for the more adventurous however, is to use country index trackers to try to beat the wider market. We know that while the market is pretty efficient, there are also various “anomalies” or factors that have been discovered to outperform consistently over time (or at least for recorded market history so far, which may not be a big enough sample size, but is the only one we have).
One such factor is “value”. In other words, if you buy cheap stuff, and give it enough time, it should rally, and beat the expensive stuff. So how does this work when looking at global equity markets?
One useful measure for valuing stock markets is the Cape ratio (sometimes known as the Shiller Cape after Professor Robert Shiller, who popularised it). This is short for “cyclically-adjusted price/earnings” ratio. It is similar to a standard price/earnings ratio, except that rather than divide the share price (or index value) by the earnings of a single year, you take the average of earnings over a period of time - usually 10 years. This helps you to smooth out the business cycle (in other words, you do not run the risk of taking a valuation based on an unusually profitable or loss-making year, such as 2008 say).
Shiller found (and plenty of other people, notably Mebane Faber of Cambria Investments) that if you buy markets when they are cheap based on Cape, your future returns are a lot higher than if you buy when the Cape is high. For example, the Cape on the US stock market fell below 10 in the early 1980s, presaging a rampant bull market from about 1982 that lasted all the way to 2000. And at the peak of the tech bubble, the Cape on the same market hit a whopping 44. That presaged nearly a decade of sub-par returns.
You cannot use the Cape as a timing tool (for example, the US has been overvalued on a Cape basis almost since the 2009 rally started). You need to be patient. But Faber’s research suggests that if you buy a market when the Cape is below 10 (when a market is very cheap), then you will typically enjoy strong returns. He suggests that one strategy would be to invest in the 25% of global markets with the lowest Capes and rebalance once a year.
It’s scary to buy cheap markets
So why does not everyone do it? For the simple reason that when markets get cheap, they get cheap for a reason. Investors prefer to see blue skies and good cheer before they invest in a market. That is why expensive markets tend to get more expensive, and cheap ones tend to keep on getting cheaper. But that is how these opportunities to outperform arise. So if you can hold your nerve and invest like a contrarian, and sit there patiently, you may be able to beat the market over time.
So what markets are cheap right now? The team at StarCapital regularly update a list of the world’s cheapest markets at their very useful website, starcapital.de. They don't just use Cape - they look at various measures such as dividend yield and book value too. It is an excellent website to pore over.
They look at 40 different global markets, using the MSCI indices (rather than each country’s benchmark index) as the basis of their calculations. By way of illustration, as of 29 March, if you wanted to invest in the five cheapest global markets, you would be buying into Russia, China, Italy, Hungary, and Singapore.
That is quite an interesting mix. Singapore is not what most of us would consider to be a scary market, but it is relatively cheap right now because of fears over a global slowdown - as Singapore is essentially one big leveraged bet on global growth, it is on the front line in any global slowdown. The story is similar for China - concerns over the strength of the economy (not to mention the veracity of accounting) hit China hard last year, although it does seem to be starting to recover. The others – Russia, Italy and Hungary – are all suffering from political turmoil of one sort or another. Political upheaval and the resultant scary headlines are often the driver of cheap market valuations. No one likes investing in a country where there is talk of collapse or chaos. And yet, it often presents a good opportunity for a bold investor.
Of course there are risks involved. Investing in an index means you do not take individual company risk which is good. But there is currency risk (the currencies in these markets are often very beaten down, but can always fall further). And there is political risk - any threat to property rights (nationalisation for example) or capital controls (which stop money – including yours – moving in and out of a country) is toxic to valuations. But that’s why you don’t just buy one of these markets – you invest in a spread. There are ETFs available for most of these markets (you might find smaller markets such as Hungary trickier to invest in – an Eastern Europe ETF might work better to cover both Russia and Hungary, for example).
And if none of those tickle your fancy, you could always invest closer to home – the good news is that given our own current political turmoil, the UK is still one of the cheaper markets out there. If you can brave the fear of Brexit and Jeremy Corbyn, you could snap up a bargain.
John Stepek is executive editor at MoneyWeek