A Prognostic Yield Measure for Country Selection in the Medium Term Using Shiller’s PE

Abstract

To reduce the complexities that advisors face in international equity investing, we have developed a measure that expresses the medium-term equity performance expectations of a country. This measure, the medium-term country yield forecast, is a simple yield forecast measure at the country level that builds on concepts that advisors already know from the widely popular cyclically adjusted price-to-earnings ratio (CAPE or Shiller’s PE). We have formulated a country yield forecasting mechanism, which applies the cyclically adjusted country yield to derive the medium-term yield forecast on an inflation-adjusted (real) basis for any country outside the U.S. The cyclically adjusted country yield of any country, which feeds into the mechanism, is nothing but its Shiller’s PE (a price multiple) expressed in yield form. The mechanism departs significantly from most applications of Shiller’s PE found in investment literature from the recent past, where Shiller’s PE is used primarily as a tool to gauge expectations of a national stock market in the long run. In our application, we use Shiller’s PE to forecast expectations in the medium run, which for us is between three- to 10-years out in the future. Moreover, the model also augments the forecasting capabilities of Shiller’s PE by incorporating into it a country’s cyclically adjusted real exchange rate.