It is a great market, isn't it? From the beginning of the
year, the S&P 500 has gained 16.4%, fueled by central banks'
quantitative easing actions around the world. We thought that the
stock market was overvalued already at the beginning of the
year...
If the central banks' goal is to elevate the stock prices, they
have done it successfully. But if their goal is to stimulate the
economy, we are not sure if they have achieved their goal. But
one thing is for sure, a higher current valuation of any asset
classes always increases the risks of investing in them. A higher
gain in the past means a lower gain in the future.
Now for the third time since 1970 (that is when our data become
available), the total market cap index is more than 100% of the
GDP. The other two times were in the late 1990s to 2000 and 2006
to 2007. Both ended badly, unfortunately.
Please see the chart below, which is from our
total market valuation page
:
Some investors may have forgotten; others were probably too young
to experience the pain. The late 1990s to 2000 stock market was
after a decade of bull market and fueled by the unprecedented
tech bubble. The total market index was pushed to about 150% of
GDP. But the burst of the tech bubble brought the S&P 500
from around 1530 in March 2000 to 800 in October 2002, a loss of
48%. The tech-heavy NASDAQ lost almost 80%. Today, 12 years
later, even after strong recoveries, it is still about 40% lower
than its peak in 2000.
The 2006 to 2007 high valuation was a byproduct of the housing
bubble. The total market index was above 110% of the GDP, which
is much lower than its 2000 peak, but it ended even worse. The
S&P 500 lost more than 56% from its peak in October 2007 to
its trough in March 2009. The economic impact was much broader
and it lasted much longer.
The quantitative easing programs started in 2009 definitely eased
investors' fear and pushed them back into stocks. What else could
they do? In 2007 an investor could buy government bonds which
yielded around 6%, or he could buy a CD with a 5% interest rate.
But what can he do today? He was told that stock dividend yield
is now higher than government bond yield, so stock is a better
investment. Now the total market index is more than 100% of the
GDP, again, the third time.
How will this one end?
At its current market valuation, though lower than it was in
2007, the implied return is actually lower than it was in 2007
because of the declined growth rate of the economy. An
alternative approach,
Shiller P/E
, is predicting an even lower return. Please see the chart below:
The chance for the stock market to do well from this point on
requires the market valuation to go even higher and stay high for
long enough so that the economy can catch up. Will this happen?
Well, nothing is impossible.
What should you do? The answer is it depends. If you are
investing other people's money and your goal is to beat the
market average, you should invest in high-quality companies that
are traded at reasonable prices, like the ones we have for our
Buffett-Munger portfolio
, which has gained 19% this year and beat the market index every
year since inception. If you are investing your own money, you
are more likely concerned about absolute returns. You don't want
to be in a situation when the market lost 40% and you "just" lost
35%. If that is the case, you may have to be patient, willing to
sacrifice short-term gains and focus more on risks and long-term
returns.
Either way, don't expect too much for the stock market from this
point on.
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