What a great year it was! The market was up 30%, the best year since the go-go years of 1990s.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.
So where are we with the market valuation and the expected return starting 2014?
Market Valuations
The ratio of Total Market Cap over GNP, Warren Buffett’s “the best single measure of where valuations stand at any given moment,” is standing at 115%. This ratio is already higher than the pre financial crisis peak of 107% and is higher than any time except for the go-go years of late 1990s, when it reached 141%. Its historical mean is around 85%. The detail is shown in the chart below:
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Shiller P/E, the cycle adjusted P/E ratio, is now at 25.6, 55.2% higher than the historical mean of 16.5.
Implied Future Market Returns
If we assume that the ratio of total market cap over GNP (Buffett’s indicator) and Shiller P/E will reverse to their mean over time, which they always did in the past, the future market returns do not look good. Using 8 years as time the market will reverse to its mean, both Buffett’s indicator and Shiller P/E suggest that the stock market will average 1% a year (2% dividends contribution included) over the next 8 years. At 1% of total market return, the market indices will be lower than they are now after 8 years.
For details of the calculation and how these indicators worked in the past, go to:
· Where Are We With Market Valuations?
· Shiller P/E – A Better Measurement Of Market Valuation
This prediction agrees with the 7-year forecast from GMO, the highly respected investment firm founded by legendary investor Jeremy Grantham.
Three Stages of Bull Market, and Three Stages of Bear Market
The implied long term negative market return is never an indicator of short term market movements. In short term the market is driven by animal spirits, which is still running high.
Howard Marks, one of the smartest investors from Oaktree Capital, describes the three stages of a bull market:
· the first, when a few forward-looking people begin to believe things will get better
· the second, when most investors realize improvement is actually underway, and
· the third, when everyone’s sure things will get better forever
He also wrote the three stages of a bear market:
· the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
· the second, when most investors recognize things are deteriorating, and
· the third, when everyone’s convinced things can only get worse
In May 2012, he thought we were at the first stages of bull market: a few forward-looking people begin to believe things will get better. In May 2013, he thought that we were somewhere in the first part of stage two.
After a gain of 30% in 2013, investors are more bullish. We don’t know which stage of bull market Howard Marks thinks we are now, but we believe that we are either at late second stage or early third stage. This is indicated by the ratio of investors’ margin debt over GDP:
Investors are borrowing money to buy stocks. This ratio now is only lower than it was in 2000.
Capital Market Indicators
As a bond investor, Howard Market gets a feel about the capital market in the first hand. One of the important indicators he looks is the easiness of capital, which is measured by BofA Merrill Lynch US High Yield CCC Or Below Option-Adjusted Spread, which now sits at 7.44%, and still going down.
Money is easy these days. The chart below is Chicago Fed National Financial Conditions Leverage Subindex. A value of -0.62 indicate that there are plenty of easy capital flooding the market.
Borrowing is easy, and corporations are enjoying the highest profit margins:
Time is good, though market valuation is high and indicates long term market negative returns. But who cares…
"As long as the music is playing, you've got to get up and dance." – Charles Prince, former CEO of Citigroup.
