Credit: Shutterstock photoIn January 2014, the stock market benchmark S&P 500 lost 3.36% after an excellent 2013. The enthusiasm came back as the market gained 4.31% over February. In March, it was essentially flat. In April, it was about even for the whole month. In May, the market gained 2.1% and in June, the S&P 500 went up 1.91%. In July, the market went down by 1.51%. However, the market gained 3.77% over August, which was the second-biggest monthly gain since 2014. Throughout October, the market benchmark S&P 500 earned 2.32% after the decline of 1.55% in September. In November, the market went up by 2.45%.
Despite S&P 500 went down by 1.32% on the first day of October, Billionaire investor Warren Buffett told CNBC on Thursday he bought stocks in Wednesday's big selloff. Buffett said he likes to buy stocks when they go down, not when they go up. "The more goes down, the more I like to buy." He said he buys businesses that he thinks will be good for the next 50 years-such as the deal to buy the nation's largest privately held car dealership group, Van Tuyl Group.
- Bill Nygren Undervalued Stocks
- Bill Nygren Top Growth Companies
- Bill Nygren High Yield stocks
- Ian Cumming Undervalued Stocks
- Ian Cumming Top Growth Companies
- Ian Cumming High Yield stocks
- John Hussman Undervalued Stocks
- John Hussman Top Growth Companies
- John Hussman High Yield stocks
In Jeremy Grantham 's GMO Q3 2014 Letter - 'Bubble Watch Update' , he mentioned:
" My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the S&P 500 on our data) before crashing as it always does .
Hopefully by then, but depending on what the rest of the world's equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement - which seems inevitably to be led by U.S. markets - starts about now, entering the sweet spot of the Presidential Cycle's year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help."
"Some would mention the very substantial overpricing of the U.S. market at the top of the list but, surprisingly, overpricing has had no material effect on third-year returns or the particularly sweet seven-month subset: an average of 17% for seven months becomes 19% if cheap and 15% if expensive. Big deal. Value, however, is very important for the other three years in which the cheapest 25% have produced a respectable return of +12%, and the other three quartiles are absolutely not worth having, all three together averaging almost exactly nil!
More disturbing to me than the obvious overvaluation is the large and growing number of other negatives - technical and psychological - put together by Hussman and other market experts. Nevertheless, despite my nervousness I am still a believer that the Fed will engineer a fully-fledged bubble (S&P 500 over 2250) before a very serious decline. "
In Daniel Loeb's Third Point Q3 2014 Investor Letter, he gives some perspectives on the current market environment:
" Going forward, we expect that the US will remain the best place to invest, credit opportunities will stay slim, and large cap opportunities with a constructivist angle will become more promising .
Although consensus has shifted to lower growth, slower inflation, modest rates, and continued monetary expansion, we think the markets will resume an overall upward trajectory in the US through year-end."
In Robert Olstein's All Cap Value Fund Q3 2014 Letter to Shareholders, he gives positive outlook on the equity market:
"Market timers must make two calls, when to sell and when to get back in. In our opinion, one market call has a low probability of being correct and with two market calls required, the chances of being correct is extremely low. We viewed the recent market decline as an opportunity to buy free cash flow companies at what we believe to be very attractive prices . While many investors are nervous about equity markets or remain sidelined waiting for accelerated economic growth, we believe there is still a strong case for investing in the equity securities of companies whose real economic value is, in our opinion, unrecognized by the market, obscured by periods of market uncertainty or overshadowed by temporary problems. Although the valuation discounts are not at the levels reached in 2009, we are able to identify companies selling at 15-20% discounts from our calculation of their intrinsic value. We are locating undervaluation in mundane businesses generating free cash flows with sound balance sheets that are far removed from the headline exciting stocks in social media, biotech, internet shopping etc., currently being purchased by the investment masses ( who we believe are paying little attention to realistic valuations based on a company's normalized ability to generate future free cash flow). We remain confident that the current environment is favorable to a long-term value investing discipline. "
In Robert Olstein's Strategic Opportunities Fund Q3 2014 Letter to Shareholders, he said:
" We believe that recent market volatility has provided an excellent opportunity to find viable investment opportunities in small- and mid-sized companies which, in our opinion, are not correctly valued by the market as a result of short term factors . In our search for value, we continue to focus on three crucial, company-specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to generate sustainable free cash flow; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders."
In John Hussman's commentary Hard-Won Lessons and the Bird in the Hand, he said:
" Meanwhile, the S&P 500 is more than double its historical valuation norms on reliable measures (with about 90% correlation with actual subsequent 10-year market returns), sentiment is lopsided, and we observe dispersion across market internals, along with widening credit spreads. These and similar considerations present a coherent pattern that has been informative in market cycles across a century of history - including the period since 2009. None of those considerations inform us that the U.S. stock market currently presents a desirable opportunity to accept risk. "
" For those investors who take a more strategic view about likely future returns, we presently estimate prospective S&P 500 10-year nominal total returns of less than 1.4% annually . Investors are being offered the choice between a quite large and easily captured bird in the hand, or two ailing, elusive and possibly imaginary birds in the bush. Our own concerns are clear, and while the immediacy of those concerns would ease in the event market internals and credit spreads improve, the 8-10 year outlook for equity returns remains dismal, and is likely to be repaired only by the downward completion of a market cycle that we currently view as almost precisely half-completed ."
In Ron Baron's Q3 2014 Review and Outlook, he said:
" Despite all the good news about our economy, we believe that global political uncertainties are the principal reason stock prices do not exceed their median levels of the past hundred years. U.S. equities are presently valued at around 15.2X 2014 earnings. The normal range in which stocks have traded for most of the past 100 years is 10X to 20X earnings. Rarely above. Rarely below. Further, stock prices are inextricably linked to our economy. In September 2014, the Dow Jones Industrial Average topped 17,000. U.S. GDP is expected to reach $17 trillion this year. In 2007, the Dow Jones Industrial Average was 14,000.The nation's GDP was $14 trillion. In 1960, when Kennedy became president, the Dow Jones Industrial Average was 600. The nation's GDP was $520 billion, less than the value of Apple today! Our nation's economy has grown at a compound annual rate of 6.7% per year in nominal terms since 1960. Our stock market has grown at an annual rate of 6.4% per year. When annual dividends of approximately 2% are added to stock appreciation, stock prices have approximately doubled every 10 years for the past 55 years. We see no reason that our nation's economy and stock markets will not continue to achieve these historic results over the long term. " He also mentioned "Berkshire Hathaway's recent purchase of a large new car dealership indicates that investor Warren Buffett is optimistic not only about the possibility of Berkshire's ability to "roll up" other auto dealers and provide car financing . He clearly also believes that a high level of new car purchases can be sustained since the average age of cars on the road has reached 11.2 years, and disposable household income is improving. When I became an investment analyst in 1970, the average age of cars in America was seven years!"
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 a lower future returns.
According to our market valuation article at the beginning of 2014, Buffett Indicator and Shiller P/E Both Imply Long Term Negative Market Returns; 2014 Market Valuation, the good news is that our account balance is higher, investors are more bullish. The bad news is that we will see lower future returns.
GuruFocus hosts three pages about market valuations. The first is the 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 US 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 Warren Buffett pointed out, the percentage of total market cap 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.
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 2001-2002 and 2008-2009, 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 Implied Returns
The information about the market valuation and the implied return based on the ratio of the total market cap over GDP is updated daily. As of December 3, 2014 , the total market cap as measured by Wilshire 5000 index is 127.9% of the U.S. GDP. We can see the equity values as the percentage of GDP are near their peaks. The only time they were higher was at the apex of the dot com bubble. The stock market is likely to return 0.6% a year from this level of valuation, including dividends in the coming years. The stock market is significantly overvalued . 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.
A quick refresher (Thanks to Greenbacked): GDP is "the total market value of goods and services produced within the borders of a country." GNP is "is the total market value of goods and services produced by the residents of a country, even if they're living abroad. So if a U.S. resident earns money from an investment overseas, that value would be included in GNP (but not GDP)."
The following chart is the Ratio of Total Market Cap over GNP (As of December 2, 2014 )
As of December 2, 2014 , the ratio of Wilshire 5000 over GNP is 1.219 .
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.
2. Dividends
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 value.
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 market.
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 as5.5% a year or aslowas -7.2% 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 27.1 . This is 63.3% higher than the historical mean of 16.6. Implied future annual return is 0.4%. The historical low for Shiller P/E is 4.8 , while the historical high is 44.2 .
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 market valuations.
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.
John Hussman's Peak P/E:
John Hussman currently estimates nominal total returns of less than 1.4% annually for the S&P 500 over the coming decade, with negative total returns over the next 8 years.
In John Hussman's commentary on December 1, 2014, " Hard-Won Lessons and the Bird in the Hand " he said " Meanwhile, the S&P 500 is more than double its historical valuation norms on reliable measures (with about 90% correlation with actual subsequent 10-year market returns), sentiment is lopsided, and we observe dispersion across market internals, along with widening credit spreads. These and similar considerations present a coherent pattern that has been informative in market cycles across a century of history - including the period since 2009. None of those considerations inform us that the U.S. stock market currently presents a desirable opportunity to accept risk. "
" The equity market is now more overvalued than at any point in history outside of the 2000 peak, and on the measures that we find best correlated with actual subsequent total returns, is 115% above reliable historical norms and only 15% below the 2000 extreme .
Unless QE will persist forever, even 3-4 more years of zero short-term interest rates don't "justify" more than a 12-16% elevation above historical norms. That increment can be calculated using any discounted cash flow method. Based on valuation metrics that are about 90% correlated with actual subsequent returns across history, we estimate that the S&P 500 is likely to experience zero or negative total returns for the next 8-9 years. At this point, the suppressed Treasury bill yields engineered by the Federal Reserve are likely to outperform stocks over that horizon, with no downside risk. The only thing that keeps this from being obvious is the proclivity of Wall Street analysts to form opinions and quote indicators without actually testing whether their methods have any reliability at all in evidence from market cycles across history. Numerous popular metrics, including the "Fed Model" and price-to-forward-earnings as a measure of value, have a very weak relationship to market returns over the following quarters or years. "
" Again, for investors with spending horizons less than about 50 years into the future, a relatively conservative stance in equities is presently encouraged solely on the principle of matching the duration of assets to spending needs, even if one has no particular view about near-term or long-term market direction .
Given current valuations, my sense is that many investors with similar spending expectations have a much greater equity exposure than is appropriate here. I certainly am not encouraging ordinary investors to sell everything, particularly those who follow a passive investment discipline. I do believe, though, that now is an extraordinarily useful time to correctly align your portfolio duration .
For those investors who take a more strategic view about likely future returns, we presently estimate prospective S&P 500 10-year nominal total returns of less than 1.4% annually. Investors are being offered the choice between a quite large and easily captured bird in the hand, or two ailing, elusive and possibly imaginary birds in the bush.
Our own concerns are clear, and while the immediacy of those concerns would ease in the event market internals and credit spreads improve, the 8-10 year outlook for equity returns remains dismal, and is likely to be repaired only by the downward completion of a market cycle that we currently view as almost precisely half-completed. "
In all the 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, Tobin's Q, or buybacks. Therefore they arrive at similar conclusions: The market is overvalued , and it is likely to return only 0.4-1.4% annually in the future years.
Jeremy Grantham's 7-Year Projection:
In Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham said " we are far off the pace still on both of the two most reliable indicators of value: Tobin's Q (price to replacement cost) and Shiller P/E (current price to the last 10 years of inflation-adjusted earnings) .
Both were only about a 1.4-sigma event at the end of March. (This is admittedly because the hurdle has been increased by the recent remarkable Greenspan bubbles of 2000 and a generally overpriced last 16 years.) To get to 2-sigma in our current congenitally overstimulated world would take a move in the S&P 500 to 2,250 ."
In GMO Q3 2014 Letter - 'Bubble Watch Update', he mentioned " My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the S&P 500 on our data) before crashing as it always does .
Hopefully by then, but depending on what the rest of the world's equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement - which seems inevitably to be led by U.S. markets - starts about now, entering the sweet spot of the Presidential Cycle's year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help."
"Some would mention the very substantial overpricing of the U.S. market at the top of the list but, surprisingly, overpricing has had no material effect on third-year returns or the particularly sweet seven-month subset: an average of 17% for seven months becomes 19% if cheap and 15% if expensive. Big deal. Value, however, is very important for the other three years in which the cheapest 25% have produced a respectable return of +12%, and the other three quartiles are absolutely not worth having, all three together averaging almost exactly nil!
More disturbing to me than the obvious overvaluation is the large and growing number of other negatives - technical and psychological - put together by Hussman and other market experts. Nevertheless, despite my nervousness I am still a believer that the Fed will engineer a fully-fledged bubble (S&P 500 over 2250) before a very serious decline. "
As of October 31, 2014, GMO's 7-year forecast is below:
Source:
https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBoe1yul9uERnhlsH5g0%2f9TpXiiwozXK2Kt0V%2f1vNRY6EalYnoVZsL4IvUeG9Saw%2bd%2fLvwgQaf5XcgEUEyo5MxgU3EOgI4ZEjqEU3s%2fTARc7g%3d%3d
GMO expected US large cap real return is -1.7% . This number does not agree with what we find out with market/GDP ratio and Shiller P/E ratio. The US high quality's return is expected to be 1.5% a year.
Insider Trends
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. market.
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.
Tobin's Q
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. He hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs.
The following graph is Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1950.
The GuruFocus Economic Indicator Tobin Q page indicates that the Q ratio is 1.120 as of April 1, 2014. This is 57.3% higher than the historical mean of 0.71 . Latest Q ratio is now the second highest in history, just following the peak of the Tech Bubble.
If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. The market may be overvaluing the company.
S&P 500 Quarterly Buybacks
The GuruFocus Economic Indicator S&P 500 Quarterly Buybacks page indicates that the preliminary S&P 500 quarter buybacks is $116.17 billion as of June 30, 2014. According to S&P Dow Jones Indices press release, "the preliminary results show that S&P 500 stock buybacks, or share repurchases, decreased 1.6% to $116.2 billion during the second quarter of 2014, down from the $118.1 billion spent on share repurchases during the second quarter of 2013. The $116.2 billion also represents a 27.1% decline over the $159.3 billion spent on stock buybacks during Q1 2014, which was the second largest on record." The slowdown in buybacks is a negative sign for the U.S. stock market . Share repurchases are the main way companies reduce the float of shares. Perhaps fewer companies like what they see when they look into the future.
The following chart is the S&P 500 quarterly buybacks since 2000 to present.
Conclusion: The stock market is not cheap as measured by long term valuation ratios. It is positioned for about 0.4-1.4% 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.
To summarize:
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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This article first appeared on GuruFocus .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
