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Finding winners in a market priced for perfection

Remember when investors used to worry about volatility? Now the problem is precisely the opposite.

All across the developed world, from commodities to stocks, normally twitchy market watchers have fallen into a deep, relaxed slumber. The VIX, the traditional "fear gauge" for the stock market, hovers near record lows. The Citigroup economic surprise index, which measures how economic data match up to expectations, is similarly soporific. Even oil prices, usually good candidates for flighty behaviour, are remarkably placid.

Stocks have rallied strongly in this benign environment, with the S&P 500 and Dow hitting so many records that another new high-water mark hardly bears mentioning. But here's the paradox: With absolutely no obvious worries to fret about, a sizable number of investors are growing stressed that the market must be missing something. They figure, to misquote Franklin Roosevelt, that all we have to fear is the lack of fear itself.

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The Financial Times, for instance, cautions that "volatility ensures discipline" and worries that a lack of volatility is leading to excesses that may not be apparent yet. Other commentators figure that any period like this must end badly, on the simple logic that things tend to revert to average, so calm must inevitably give way to turmoil.

If so, maybe it's time to get out in front of the crowd and consider a radical solution: Creating your own volatility.

In North America, the current don't-worry-be-happy mentality has propelled stocks to lofty levels. In fact, the cyclically adjusted price-to-earnings (CAPE) ratio, a measure of how current share prices stack up against average earnings over the past 10 years, suggests that U.S. stocks are priced for something close to perfection. They're trading at close to 26 times CAPE earnings, far above the 16 or so that has been the historical norm.

The expensive valuations make sense only if you figure that markets are going to continue on their current smooth upward course, bolstered by a U.S. recovery and low interest rates.

If you don't buy that happy scenario, the obvious thing to do is to look for cheaper, riskier markets elsewhere – which is exactly what Mebane Faber urges.

Mr. Faber, a portfolio manager at Cambria Investment Management, is a big fan of the CAPE ratio, but admits it's far from perfect. He points out, for instance, that an investor who sold all her stocks when CAPE moved significantly above its long-term average would have been out of the U.S. stock market since 1993.

Mind you, that wouldn't have been total disaster. A U.S. investor who moved all her money into 10-year U.S. government bonds would have produced an average annual 6.3-per-cent return since 1992. While that would have lagged the 9.3-per-cent return of the stock markets, the bond investor would also have missed out on two terrifying bear markets, in which stocks lost up to half their value.

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She could have done even better, Mr. Faber writes, by moving into the world's cheapest stock markets, as measured by CAPE. He calculates that an investor who systematically invested in the most inexpensive 25 per cent of countries around the world, and adjusted her portfolio yearly, would have produced a 17-per-cent-a-year average return.

Right now, a strategy of buying cheap companies on the basis of the CAPE ratio would put you into Brazil, Greece, Russia and emerging Europe. The prospect of investing in any of those countries is likely to cost you a few sleepless nights – but if you're pining for volatility, it could be exactly what you need.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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