Can You Outperform the Market Based on Fundamentals? : Evidence from Datastream Country Indices

We have investigated the regime-switching role of different price to earnings (P/E) variants. Two-regime asset pricing models allow us to estimate critical levels above and beyond markets exhibit different systematic risk and abnormal return. However, whether the regime switch is from a less risky to a riskier state is highly dependent on the P/E variant and on the specific market it has been employed. In developed markets P/E ratios are sentiment measures and high values do not necessarily indicate overpricing. Both in developed and in emerging markets the use of local P/E can be misleading, as alone, it cannot take into account the global sentiment and the local circumstances at the same time. The relative P/E (RPE); that is, the ratio of local to global P/E appears to be the best tool to detect underpriced/overpriced markets both in the developed and in the emerging world.