Now's the time to leap into Greece, forge into Ireland and load up on Italy. At least, that is, if you trust in research showing that beaten-down stock markets tend to stage strong recoveries.
In a paper published this week, Mebane Faber of Cambria Investment Management in El Segundo, Calif., presents evidence that consistently buying the world's cheapest stock markets can boost your returns by four percentage points or more a year.
There is, as you might expect, a catch involved. To get the biggest returns of all, you have to be prepared to invest in markets that would send most investors screaming into the night – places like Greece right now, Ireland in 2008, Thailand in 2000 and South Korea in 1984, 1985 and 1997. "Can you imagine investing in any of these markets in those years?" Mr. Faber writes. "In every instance the news flow was horrendous and many of these countries were in total crisis."
Yet the lucky few investors who were able to overcome their gag reflexes did very well, according to Mr. Faber. He calculates that, on average, they would have enjoyed real annual returns of 30 per cent in the three years following such market crises.
Of course, not every cheap market is automatically a good buy. Mr. Faber's preferred yardstick for finding undervalued situations is the cyclically adjusted price-to-earnings ratio (CAPE) developed by Robert Shiller, an economist at Yale University.
CAPE measures a stock market's price in comparison to the average annual earnings produced by the underlying companies over the past 10 years, adjusted for inflation. You can think of CAPE as a P/E ratio for the entire market – but one that is based on the market's ability to produce earnings over an entire business cycle, rather than just a single year.
In his paper, entitled Global Value: Building Trading Models with the 10-Year CAPE, Mr. Faber argues that you get better returns by investing in a market when it's cheap than when it's expensive. Good times to buy stocks come when a market is trading for a CAPE of about 10 or less. The best opportunities of all occur when the CAPE is five or less – which it was in each of the crises mentioned above.
Conversely, returns to investors deteriorate as the CAPE climbs higher, indicating that stocks are getting more expensive. In June, when Mr. Faber measured various international markets, Canadian stocks ticked in with a CAPE of more than 17, while U.S. stocks registered nearly 21. Based on Mr. Faber's calculations, that suggests real annual compound returns over the next decade of around 8 per cent for Canadian stocks and 5.7 per cent for their U.S. counterparts.
Investors who want more and have stainless steel nerves might want to consider some of the world's cheapest markets, most of which are now found in the euro zone. Be prepared, though, for a wild ride. Market crises can produce big returns but results are unpredictable. The only certainty is that they will take a toll on your stomach lining.
Cyclically adjusted price-earnings ratio as of June, 2012.
Source: Cambria Quantitative Research