Is the bull market about to end?
Leading value investors have long used a handful of fundamental indicators to determine where the stock market stands at any given time.
These indicators, used in conjunction with a long-term investment outlook, can quickly identify good and bad times to buy stocks.
The first of these is what Warren Buffett (Trades, Portfolio) called, "probably the best single measure of where valuations stand at any given moment."
It is the ratio of Total Market Cap to Gross Domestic Product (GDP). The higher the percentage, the more overpriced and risky the stock market is believed to be.
In March 2014, Total Market Cap to US GDP reached 118.0% - the highest level in over 40 years with the exception of the 1999 tech bubble.
This put the market in Significantly Overvalued territory. From these prices, the US market has an expected future return of just 1.6% annually.
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Another widely used economic indicator is the Shiller P/E Ratio. Unlike traditional P/E ratios, the Shiller model eliminates fluctuations caused by varying profit margins across the business cycle. As with the previous example, the lower the number the better.
As you can see, US markets are approaching 2007 pre-crash levels that have only been exceeded twice - the 1999 tech bubble and the year before the Great Depression. And we both knkow how those turned out.
The third stock market valuation clue comes from interest rates.
Interest rates "act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government rates fall, the move pushes the prices of all other investments upward." - Warren Buffett (Trades, Portfolio)
The chart above shows interest rates (measured by the 10-year Treasury note) over the last 50 years. As the economy strengthens and interest begin to rise, we are very likely to see stock prices suffer as bond yields increase. In fact, loan rates have already begun to increase.
Market Overvalued, How to Invest?
Stay defensive! Use the GuruFocus Buffett-Munger Screener to find high quality companies at undervalued prices. The portfolio of Buffett-Munger companies has outperformed the market every year.
Once the market becomes undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener.
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"As discussed earlier, the high tech stocks were soaring – particularly those with no earnings and very little revenue. Tesla Motors, for example, sold 22,477 cars in 2013 but commands a market cap of $31 billion, while Fiat, which we like, sold 4.4 million cars but has a market cap of only $14 billion. Amazon has a market cap of $167 billion but has not earned more than $1.2 billion in any one year since it went public in 1999. Facebook has recently made a $19 billion offer for WhatsApp – a company with approximately 50 employees and $20 million in revenue. This is the poster child for the excesses that prevail in the tech world!" - Prem Watsa, Fairfax Financial Holdings (Shareholder Letter, March 2014)
