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Market Valuations and Expected Returns as of February 2012

February 01, 2012 | About:
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gurufocus

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Stock market had one of the best Januarys for a long time, the S&P 500 index was up 4.4%. It is nice to see the balances of you and your clients’ accounts higher. But higher past returns always imply lower future returns. Now it is time to review the general market valuation and the expected returns again.

GuruFocus hosts two 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. Both pages are updated at least daily. By the way, we have also created a new page for international markets. You can take a peek here.

Why is this important?

As pointed out by Warren Buffett, 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.

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 stock 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 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. The Stock Market is modestly overvalued. Based on historical ratio of total market cap over GDP (currently at 91.8%), it is likely to return 4.9% a year from this level of valuation.

For comparison, a month ago, the ratio of total market cap over GDP was 87.4%, it is likely to return 5.7% a year from that level of valuation.

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 thelong 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 a exact number. The return can be as high as 10% a year or as long as -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 21.7 as of today, 32.3% higher than the historical mean of 16.4. The implied market return is 3.2%. Compared with a month ago, Shiller P/E was 20.7 as of today — 26.2% higher than its historical mean of 16.4. The implied annual return was 3.9% over the next eight years. 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 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 below 5% a year. This agrees with the returns projected by the ratio of total market cap over GDP and Shiller P/E. This is the chart of the actual S&P 500 10-year annual total return and the projected return by John Hussman:

wmc120123b.gif

Jeremy Grantham’s 7-Year Projection:

Jeremy Grantham’s firm GMO publishes a monthly 7-year market forecast. The latest 7-year forecast published by GMO is below:

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GMO is even more pessimistic about the market return. Their expected US large cap return is 1.4%. The US high quality will have high return. The return is expected to be 5.3% 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 can 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 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.

Conclusion: The market is not cheap. It is positioned for about 4-6% of annual returns for the next decade. But 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.

About the author:

gurufocus
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.6/5 (12 votes)

Comments

Harney246
Harney246 premium member - 2 years ago


Thank you for a good job assembling and communicating the information.

Please leave your comment:


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