In the first three quarters of 2013, the year-to-date return for
the stock market benchmark S&P 500 is 18.04%. It gained 2.97%
in September, the fourth biggest monthly gain since 2013, after
5.69% in July, 3.36% in March and 3.04% in May. The market reached
its second historical high on Aug. 2, 2013. On Sept. 18, 2013, it
reached its highest point at 1725.52.
In the Federal Open Market Committee's (FOMC) September meeting,
members of the Federal Reserve's monetary policy-making body saw
financial situations as tighter and a risk from "sizable increases
in interest rates." Most members still anticipated tapering of
quantitative easing happening later this year. FOMC forecasted the
easing in the effects of fiscal policy restraint on economic
growth. Some of the members saw the increasing risk of the fiscal
policy. Quoting from the minutes of the FOMC, "Participants
continued to project the rate of growth of economic activity to
strengthen over coming years, supported by highly accommodative
monetary policy and the gradual abatement of the headwinds that
have been slowing the pace of economic recovery, such as
household-sector deleveraging, tight credit conditions for some
households and businesses, and fiscal restraint."
As investors are happier with the higher balances in their account,
they should never forget the word "RISK," which is directly linked
to the valuations of the asset they own. A higher current valuation
always implies lower future returns.
GuruFocus hosts three pages about market valuations. The first is
market valuation based on the ratio of total market
cap over GDP
; the second is the measurement of
the U.S. market valuation based on the Shiller P/E
. These pages are for the U.S. market. We have also created a new
page for international markets.
You can check it out here
. All pages are updated at least daily. Monthly data is displayed
for the international market.
Why Is This Important?
As pointed out by
, the percentage of total market cap (TMC) relative to the U.S. GNP
is "probably the best single measure of where valuations stand at
any given moment."
Knowing the overall market valuation and the expected market
returns will give investors a clearer head on where we stand for
future market returns. When the overall market is expensive and
positioned for poor returns, the overall market risk is high. It is
important for investors to be aware of this and take consideration
of this in their asset allocation and investing strategies.
Please keep in mind that the long-term valuations published here do
not predict short-term market movement. But they have done a good
job predicting the long-term market returns and risks.
Wise man Howard Marks also pointed out that investors should always
know where we are with the market. Predicting the direction of the
market is hard. But investors can always make educated decisions
based on current conditions.
Howard Marks thinks that "most assets are neither dangerously
elevated (with the possible exception of long-term Treasury bonds
and high grades) nor compellingly cheap. It's easier to know what
to do at the extremes than it is in the middle ground, where I
believe we are today". He wrote in his latest memo.
Why Did We Develop These Pages?
We developed these pages because of the lessons we learned over the
years of value investing. From the market crashes in 2001 to 2002
and 2008 to 2009, we learned that value investors should also keep
an eye on overall market valuation. Many times value investors tend
to find cheaper stocks in any market. But a lot of times the stocks
they found are just cheaper, instead of cheap. Keeping an eye on
the overall market valuation will help us to focus on absolute
value instead of relative value.
The indicators we develop focus on the long term. They will provide
a more objective view on the market.
Ratio of Total Market Cap over GDP - Market Valuation and
The information about the market valuation and the implied return
based on the ratio of the total market cap over GDP is updated
daily. The total market cap as measured by Wilshire 5000 index is
now 112.4% of the US GDP. The stock market is likely to return
a year in the coming years. As a comparison, at the beginning of
2013, the ratio of total market cap over GDP was 97.5%, and it was
likely to return 4% a year from that level of valuation. The 18.04%
gain since the beginning of 2013 has reduced the future gains by
about 1.9% a year.
For details, please go to the daily updated page. In general, the
returns of investing in an individual stock or in the entire stock
market are determined by these three factors:
1. Business Growth
If we look at a particular business, the value of the business is
determined by how much money this business can make. The growth in
the value of the business comes from the growth of the earnings of
the business growth. This growth in the business value is reflected
as the price appreciation of the company stock if the market
recognizes the value, which it does, eventually.
If we look at the overall economy, the growth in the value of the
entire stock market comes from the growth of corporate earnings. As
we discussed above, over the long term, corporate earnings grow as
fast as the economy itself.
Dividends are an important portion of the investment return.
Dividends come from the cash earning of a business. Everything
equal, a higher dividend payout ratio, in principle, should result
in a lower growth rate. Therefore, if a company pays out dividends
while still growing earnings, the dividend is an additional return
for the shareholders besides the appreciation of the business
3. Change in the Market Valuation
Although the value of a business does not change overnight, its
stock price often does. The market valuation is usually measured by
the well-known ratios such as P/E, P/S, P/B, etc. These ratios can
be applied to individual businesses, as well as the overall market.
The ratio Warren Buffett uses for market valuation, TMC/GNP, is
equivalent to the P/S ratio of the economy.
Putting all the three factors together, the return of an investment
can be estimated by the following formula:
Investment Return (%) = Dividend Yield (%)+ Business Growth
(%)+ Change of Valuation (%)
From the contributions we can get the predicted return of
The Predicted and the Actual Stock Market Returns
This model has done a decent job in predicting the future market
returns. You can see the predicted return and the actual return in
the chart below.
The prediction from this approach is never an exact number. The
return can be as high as 10% a year or as low as -6% a year,
depending where the future market valuation will be. In general,
investors need to be cautious when the expected return is low.
Shiller P/E - Market Valuation and Implied Returns
The GuruFocus Shiller P/E page indicates that the Shiller P/E is
. This is 43% higher than the historical mean of
Implied future annual return is
As a comparison, the regular trailing 12-month P/E is 19, higher
than the historical mean of 15.8. That is also why the media
pundits are saying that the market is cheap.
Twelve months ago, Shiller P/E was 21.8, and regular trailing
12-month P/E was around 15. The market did look cheap with trailing
The Shiller P/E chart is shown below:
Over the last decade, the Shiller P/E indicated that the best time
to buy stocks was March 2009. However, the regular P/E was at its
highest level ever. The Shiller P/E, similar to the ratio of the
total market cap over GDP, has proven to be a better indication of
Overall, the current market valuation is more expensive than the
most part of the last 130 years. It is cheaper than most of the
time over the last 15 years.
To understand more, please go to GuruFocus' Shiller P/E page.
's Peak P/E:
John Hussman uses the peak P/E ratio to smooth out the distortion
of the corporate profits caused by the fluctuations of the profit
margins. The current market return projected by his model is less
In his commentary on Sept. 23, 2013, Psychological Ether, he
estimates a likely total return for the S&P 500 over the coming
decade of less than 2.9% annually. He continued to believe that
present conditions warrant a generally defensive outlook. "One
hardly needs to accept any of these concerns to recognize that
current equity valuations are consistent with the likelihood of
dismal long-term returns. The historical record of
valuation measures should be sufficient. The chart below
illustrates the relationship between the S&P 500 price/revenue
ratio and subsequent 10-year nominal annual total returns for the
S&P 500. "
"On that front, the chart below shows the value of nonfinancial
corporate equities to GDP (imputed from March to the present based
on changes in the S&P 500). On this measure, the likely
prospective 10-year nominal total return of the S&P 500 lines
up at somewhere less than zero. Suffice it to say that our
estimates using both earnings and non-earnings based measures
suggest a likely total return for the S&P 500 over the coming
decade of less than 2.9% annually, essentially driven by dividend
income, and implying an S&P 500 that is roughly unchanged a
decade from now - though undoubtedly comprising a volatile set of
market cycles on that course to nowhere."
This agrees with the returns projected by the ratio of total market
cap over GDP and Shiller P/E.
In all the three approaches discussed above, the fluctuations of
profit margin are eliminated by using GDP, the average of trailing
10-year inflation-adjusted earnings, and peak-P/E, revenue or book
value, etc. Therefore they arrive at similar conclusions: The
market is overvalued, and it is likely to return only 1.9% to 2.9%
a year in the future years.
's 7-Year Projection:
Jeremy Grantham's firm GMO publishes a monthly seven-year market
forecast. According to Ben Inker and James Montier's quarterly
letter What the *&%! Just Happened? and The Purgatory of Low
Returns, it noted that today's opportunity set is characterized by
almost everything being expensive. James Montier believes this is a
direct effect of the quantitative easing policies being pursued by
the Federal Reserve and their ilk around the world. James Montier
advises that investors should "be patient" at this point.
As of September 30, 2013, GMO's 7-year forecast is below:
|US High Quality
||Inflation Linked Bonds
|Intl Bonds Hedged
GMO expected that the U.S. large cap real return is -2.0%. This
number does not agree with what we find out with market/GDP ratio
and Shiller P/E ratio. The U.S. high quality's return is expected
to be 3.3% a year.
As indicated by the three different approaches discussed above, the
best buying opportunities over the last five years appeared when
the projected returns were at their highest level from October 2008
to April 2009, when investors could expect 10% a year from the U.S.
If average investors missed this opportunity, corporate insiders
such as CEOs, CFOs and directors did not. As a whole they purchased
their own company shares at more than double the normal rate from
October 2008 to April 2009. Many of these purchases resulted in
multi-bagger gains. This confirmed again the conclusions of earlier
studies: The aggregated activities of insiders can serve as a good
indicator for locating the market bottoms. Insiders as a whole are
smart investors of their own companies. They tend to sell more when
the market is high, and buy more when the market is low.
This is the current insider trend for S&P 500 companies:
The latest trends of insider buying are updated daily at GuruFocus'
Insider Trend page. Data is updated hourly on this page. The
insider trends of different sectors are also displayed in this
page. The latest insider buying peak is at this page: September of
2011, when the market was at recent lows.
The stock market is not cheap as measured by long-term valuation
ratios. It is positioned for about
1.9% to 2.9%
of annual returns for the next decade. By watching the overall
market valuations and the insider buying trends investors will have
a better understanding of the risk and the opportunities. The best
time to buy is when the market valuation is low and insiders are
enthusiastic about their own company's stocks.
Investment Strategies at Different Market Levels
The Shiller P/E and the ratio of total market cap over GDP can
serve as good guidance for investors in deciding their investment
strategies at different market valuations. Historical market
returns prove that when the market is fair or overvalued, it pays
to be defensive. Companies with high-quality business and strong
balance sheet will provide better returns in this environment. When
the market is cheap, beaten down companies with strong balance
sheets can provide outsized returns.
1. When the market is fair valued or overvalued, buy high-quality
companies such as those in the Buffett-Munger Screener.
2. When the market is undervalued, buy low-risk beaten-down
companies like those in the Ben Graham Net-Net Screener. Buy a
basket of them and be diversified.
3. If market is way over valued, stay in cash. You may consider
hedging or short.
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