Research in Charts

StarCapital examines long-term relationships of capital markets and take advantage of these insights in its fund management. Selected internal research insights and their relationships are presented graphically.

Financial Pitfalls

Short-term forecasts, market timing and EPS estimations are just three pitfalls investors should be aware of.  The following charts focus on some rarely discussed fallacies in the financial markets.

Don't trust analysts’ forecasts: always positive, no predictive power

Every year in December, well-respected banks publish their next year’s stock market forecasts. Investigating the relation of these forecasts and reality, it turns out that these elaborated forecasts don’t predict future performances better than most naive forecasts. For instance, banks forecasts weren’t more precise than assuming a constant yearly stock market return of 9%. This result remains true for every arbitrarily chosen return between 7% and 19%!

From our point of view, short-term performance is not predictable – hence, we renounce developing short-term predictions.

EPS estimations are subject to tremendous errors

The basic idea behind Discounted Cash Flow models is that a company’s value equals its discounted future earnings and cash flows. Unfortunately, even tiny misjudgments of the long-term earnings growth have a big impact on the resulting company’s value. Taken into account that the average error of analysts next year’s EPS forecasts since 1973 is 30%, nearly any company value – and hence any stock value – could be justified based on DCF models.

Thus, we avoid predicting short-term earnings.

Country Allocation

A reasonable country and sector allocation can be developed without short-term forecasts. The following charts focus on the relationship between fundamental valuations and the resulting long-term stock market potential.

CAPE as a reliable indicator for future long-term performance

Valuation ratios such as the cyclically adjusted Shiller PE (=CAPE) are strongly related to the long-term returns as exemplary shown in the S&P 500 since 1881. In this time, the CAPE has significantly exceeded its long-term average four times. Investors who invested in these overvaluations generally experienced real losses over periods of 10-20 years.

Details can be found in our research study Predicting Stock Market Returns Using the Shiller CAPE.

Low valuations are followed by above-average stock market returns

Long-term stock market returns can be predicted from its valuation. The chart illustrates this relationship based on various indicators (Shiller-CAPE, price-to-earnings, price-to-book and price-to-cash-flow ratios, as well as dividend yield). Analyzing the period from 1979 to 2015, for all indicators, we found that low (=cheap) valuations were followed by higher long-term returns than high (=expensive) valuations. Therefore, investors should mainly invest in undervalued stock markets and avoid expensive markets.

Details can be found in our research study Predicting Stock Market Returns Using the Shiller CAPE.

What long-term returns can investors consequently expect worldwide?

By 12/31/2019, the US stock market's CAPE and PB are 31.1 and 3.6, respectively. During the last 140 years, comparable valuations only led to below-average annual returns of 2.7% for the following 10-15 years. With a CAPE of 18.9 and PB of 1.7, German stocks promise considerably higher returns. The highest long-term returns can be expected for the Emerging Markets.

Details on the calculation methodology can be found in our research study Predicting Stock Market Returns Using the Shiller CAPE.

Example DAX 30: What kind of stock market returns can investors expect?

In comparison, the German stock market offers a much higher return potential; In the past 140 years, periods with valuation levels comparable to the current CAPE and PB of the DAX were followed by average long-term annual returns of 6 percent. In the majority of all historical observation periods, real capital gains of 4-9% were achieved. Considering inflation, in 2034, a DAX level of 32,000-60,000 is most likely.

The worst-case analysis also appears interesting. This represents the worst possible performance that followed a valuation comparable to today since 1871, i.e. including the two world wars and the great depression of 1929. Even if such scenarios occur, the DAX should hold roughly the current level in 15 years.

Chart with additional methodological details

We calculated such a scenario corridor for the first time at the beginning of 2014. This is shown here, with only the current DAX development being supplemented. So far, the DAX has traded within the ranges expected at the time and the long-term likely price developments are still very similar to the forecasts made at the time.

Details on the calculation methodology can be found in our research study Predicting Stock Market Returns Using the Shiller CAPE.

High valuations also indicate higher downside risks

Valuation levels do not only forecast future long-term returns but also indicate impending downside risks. From 1979 to 2015, attractive valuations were followed by lower price declines than high valuations, as displayed in the chart. For all indicators under consideration, divided into five quintiles, the chart shows the maximum losses investors could have suffered if they had sold at the worst point in time. Under these circumstances, the downside risk of stock markets increase with rising valuation levels. Thus, also seen from a risk perspective, investors should avoid expensive stock markets.

Details can be found in our research study Predicting Stock Market Returns Using the Shiller CAPE.

However, structural changes may impair Shiller-CAPE's validity...

Not every attractive valuation necessarily leads to a buy opportunity. Especially, the cyclically adjusted Shiller-CAPE shows considerable shortcomings in markets with structural changes, such as changes in index composition. For example, it is not very meaningful to calculate the CAPE for the MSCI Greece, where the number of stocks varied from 2 to 22 during the last 10 years and the average earnings are based on a no longer existing financial sector. Thus, the CAPE should mainly be used in larger indices with stable compositions.

...also different sector compositions impair comparisons between countries

Apart from structural changes, other factors can impair the comparison among countries. Considering Denmark, the chart illustrates the effect of differing sector weights and suggests possible adjustments for valuation ratios. The Healthcare sector is represented in the MSCI Denmark with a weight of 45%, whereas the MSCI World invests only 9% in this sector. This leads to drastic consequences in the valuation: with an average PB of 4.5 since 1995, Healthcare-stocks were valued about 90% higher than other sectors. Can an index with a weight of 45% in such expensive sectors ever get to a neutral valuation level?

Can the US-overvaluation also be explained by its high Technology weight?

Also the overvaluation of the US stock market has to be relativized a little if differences in sector compositions are taken into account. Measured by PB, the US market trades at a valuation premium of 52% compared to the global stock market. By taking into account that the US market is strongly invested in the expensive Technology sector, a sector adjustment decreases the overvaluation. However, even with adjusting, a significant overvaluation of 30% remains.

Factor Investing

After identifying attractive countries and sectors, the question arises how to invest in a meaningful way. As numerous studies have proven before, some factor strategies outperform their benchmarks in the long-run, which the following charts will demonstrate.

The value comeback is overdue: US value premium since 1926

Academic research provides evidence that the outperformance of value stocks (HML) towards growth stocks in the long-run is subject to substantial cycles. Since 2008, Value investors have been underperforming. This is the longest Period of Losses in History. However, these periods were followed by value-strong years.

Can value strategies be optimized by considering momentum indicators?

A fundamental undervaluation does not indicate when stock prices will rise. In fact, value-investors tend to invest too early, and often buy stocks that continue to depreciate. An undervaluation of a company is worthless until other investors recognize the undervaluation and begin buying the stock, causing its price to appreciate. Thus, momentum indicators can improve investment timing which is backed by our research results.

Contact Us

For queries or additional information please contact:


Norbert Keimling
Head of StarCapital Research
info(at)starcapital.de