While investors remain understandably leery about the economic environment in the new year, many are looking to various corners of the market for more meaningful and stable returns. Mebane Faber, PortfolioManagerat Cambria InvestmentManagementand co-founder of AlphaClone, recently took the time to discuss which trends investors are likely to see developing in 2013 and how the innovative CAPE ratio can help investors pick more promising investments. ETF Databse (ETFdb): Looking further in 2013, what are the two or three most compelling macroeconomic themes that you see developing?

Mebane Faber (MF): We have spent a lot of time thinking about how investors approach the equity markets. Many investors come from a market capitalization standpoint or have a home country bias, which causes these investors to overweight the biggest countries or their home country. We started searching for a better way of building an index of countries. By applying the Shiller cyclically adjusted 10-year price-to-earnings ratio (CAPE) to over 40 countries we did find a way to gain exposure to countries based on valuation, instead of pure market cap weighting .

ETFdb: Can you just give a brief explanation of the CAPE ratio and why you follow it?

MF: The concept of smoothing earnings over multiple years is nearly 70 years old and goes back to Graham and Dodd. Robert Shiller popularized the theory with a paper and his book Irrational Exuberance in the 1990s, where he focused on smoothing earnings over 10 years and then adjusting for inflation. This helps to smooth out the peaks and valleys that normally happen over the course of a full business cycle. The typical CAPE ratio is between 15 and 20, with bubbles occurring around 30 and bottoming out around seven.

ETFdb: From a risk-reward perspective, should risk tolerant investors focus in on domestic equities or foreign ones?

MF: From a traditional standpoint of the U.S. investor there are a number of factors to consider. The U.S. market, by most standards, is trading at an overvalued level featuring a CAPE ratio of 21, which is on the more expensive side. But if you look to foreign countries, many are trading at lower levels, for example, Greece, Ireland, Italy and many other European nations that are recovering from economic slumps are trading at record low levels and could offer great potential returns for U.S. investors .

ETFdb: In your opinion, which regions or countries offer the most lucrative investment cases and why? Are there specific ETFs that you prefer for accessing these?

MF: We always recommend buying a basket of countries to even out your risks and returns. But at the country level both Greece and Ireland are trading at CAPE ratios below five, which has historically led to very strong returns for the next five to even 10 years. There are also countries like Russia, Austria, Italy and Belgium that are trading at CAPE ratios under 10, which makes now a great time to invest.

ETFdb: What are the noteworthy risks surrounding the opportunities highlighted above?

MF: Greece is a perfect example, because at one point it was trading at a CAPE ratio of 10, and an investor could have called that the bottom, but they would have lost when the ratio fell to two. Value investing takes on the behavioral biases of people selling assets when they are down. You can lose a lot of money trying to catch the bottoms, which is partly why we recommend a basket of countries instead of just one. Investors also need to look out for P/E ratio compression because of high inflation rates, because these funds might look appealing but in a rising inflation environment they are not. We also follow trends, set maximum P/E ratios, and use other practical tools when forming a portfolio .

Bottom Line: When choosing where to park your investments, whether it be domestically or abroad, a great tool to use is the CAPE ratio, as it places an emphasis on valuation instead of traditional cap-weighting. Investors should, however, be mindful of the level of diversification that foreign equity ETFs offer, as this will play a big role in the risk/return profile of the investment.

Follow me on Twitter@SBojinov

Disclosure: No positions at time of writing.

Related Articles
  1. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares US Basic Materials

    Learn about the iShares US Basic Materials exchange-traded fund, which invests in the equities of chemicals, metals and industrial gas companies.
  3. Mutual Funds & ETFs

    ETF Analysis: Ultra Oil & Gas

    Find out more about the ProShares Ultra Oil & Gas exchange-traded fund, the characteristics of the ETF and the suitability and recommendations for the fund.
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  6. Mutual Funds & ETFs

    Comparing ETFs Vs. Mutual Funds For Tax Efficiency

    Explore a comparison of mutual funds and exchange-traded funds, or ETFs, and learn what makes ETFs a significantly more tax-efficient investment.
  7. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Corp Bd

    Learn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
  9. Insurance

    Whole or Term Life Insurance: Which Is Better?

    Learn the difference between term life insurance and whole life insurance. Understand when it is beneficial to buy each type of life insurance.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares 10-20 Year Treasury Bond

    Learn about the iShares 1-20 Year Treasury Bond ETF and its holdings, and understand why investors may be better served to look at other bond funds.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Fractal Markets Hypothesis (FMH)

    An alternative investment theory to Efficient Market Hypothesis ...
  5. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  6. Sucker Yield

    When an investor has essentially risked all of his capital for ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!