In the first half of 2013, the stock market gained 2.44% in January, 0.10% in February, 3.36% in March, 2.27% in April and 3.04% in May. This is after a double-digit return gain in 2012. There is a saying that if the market is up in January, it will be up for the year. We don’t know if this is true, but it looks that way at least so far this year. 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.
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 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 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.
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.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
. The total market cap as measured by Wilshire 5000 index is now 107.5% of the US GDP. The stock market is likely to return about 2.7% 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%, it was likely to return 4% a year from that level of valuation. The 10% gain since the beginning of 2013 has reduced the future gains by about 1.3% 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. 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.