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Market Valuations and Expected Returns - June 5, 2014

June 05, 2014 | About:
Vera Yuan

Vera Yuan

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In January 2014, the stock market benchmark S&P 500 lost 3.36% after the excellent 2013. The enthusiasm went back as the market gained 4.31% over February. In March, it went up only 0.69%. In April, it was about even for the whole month. And in May, the market gained 2.10%.

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.

In Jeff Auxier’s Auxier Report - First Quarter 2014, he said, “Speculation abounds in the stock market. We live in a world where data generation is exponential, and supply gluts can develop rapidly, especially in times of euphoria. The Economist recently revisited five financial crises, and the conclusion can be summed up by Walter Bagehot, the magazine’s editor-in-chief from 1860 to 1877. He argued that financial panics come when “blind capital” floods into unwise speculative investments. Today, over 70% of the companies that have come public the last six months have no earnings, and have been priced over ten times sales.1 By comparison, the typically profitable S&P 500 stocks average 1.7 times sales.

In our interview with Brian Rogers on April 22, 2014, “T. Rowe Price Chief Investor Brian Rogers Answers Investors' Questions,” when he answered “Question 4: How much cash do you take in your fund? Is the cash position stable or do you tend to build up cash while the market becomes expensive? Also, how is your current personal private asset allocation (percent cash and cash equivalents, percent bonds, percent equity, percent alternative)?” he said “The cash position in my fund is currently about 7%, which is up from 3-4% a year ago. It seems to me that there are fewer compelling opportunities today. Price earnings ratios are somewhat higher and our investment analysts have fewer buy rated recommendations. In my opinion there are more stocks to sell than there are to buy today. In terms of my personal asset allocation, I do not practice what I preach when it comes to the benefits of diversification, as 80% of my net worth is in T. Rowe Price stock. Ten percent is in our cash and fixed income funds and ten percent is invested in several T. Rowe Price equity funds, including the Equity Income Fund.”

In Chuck Akre’s Focus Fund First Quarter 2014 Commentary, he said, “We are not in the camp that feels the market is pricing businesses too richly. However, it is true that businesses, in general, are more richly valued than they were a year or two ago. As a generalization we have made no new purchases in businesses during the quarter, but it will not surprise you that we have our eyes on several.”

In Dodge & Cox’s First Quarter 2014 Commentary, it mentioned, “After exceptionally strong returns in 2013, the S&P 500 posted a modest gain during the first quarter of 2014 and remained near record highs at March 31. Investors responded favorably to the U.S. Federal Reserve's statement that its low interest-rate policy is still needed to support U.S. economic growth. Such acknowledgement eased concerns that interest rates might be increased sooner than expected. U.S. economic data was generally positive; the U.S. labor market exhibited marginal improvement, household spending increased, and businesses invested more in fixed assets. Corporate balance sheets continue to be robust. However, the U.S. economy still faces hurdles, including modest economic growth, an elevated unemployment rate, and a slowing recovery in the housing market.

Despite recent gains, we continue to believe U.S. equity market valuations are reasonable: the S&P 500 traded at 15.2 times forward estimated earnings with a 2.0% dividend yield at quarter end.”

In Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham stated, “Best Guesses for the Next Two Years: With the repeated caveat that prudent investors should invest exclusively or nearly exclusively on a multi-year value forecast, my guesses are:

1) That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.

2) But after October 1, the market is likely to be strong, especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.

3) And then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”

In John Hussman’s commentary on May 26, 2014, “Exit Strategy,” he said, “The S&P 500 set a marginal new high on Friday, in the context of a broad rollover in momentum thus far this year that we view as likely – though of course not certain – to represent a broad cyclical peak of the sort that we observed in 2000 and 2007, as distinct from spike-peaks like 1987. Valuation measures remain extreme, with the market capitalization of nonfinancial stocks pushing 130% of GDP (relative to a pre-bubble norm of about 55%), the S&P 500 price/revenue ratio at 1.7, versus a pre-bubble norm of 0.8, and the Shiller P/E near 26 – which while lower than the 2000 extreme, exceeds every pre-bubble observation except for a few months approaching the 1929 peak. We presently estimate 10-year nominal total returns for the S&P 500 Index averaging just 2.3% annually, with zero or negative total returns on every horizon shorter than about 7 years.”

According to our last market valuation article, 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 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.

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

1401994952875.png

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 June 5, 2014, the total market cap as measured by Wilshire 5000 index is 119.3% of the US 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 about 1.4% a year 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 June 3, 2014)

1401995151631.png

As of June 3, 2014, the ratio of Wilshire 5000 over GNP is 1.174.

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.

1401995244341.png

The prediction from this approach is never an exact number. The return can be as high as 6.4% a year or as low as -6.5% 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 25.6. This is 55.2% higher than the historical mean of 16.5. Implied future annual return is 1.0%. 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:

1401997481008.png

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 presently estimates prospective 10-year S&P 500 nominal total returns falling below 2.2% annually, with negative expected total returns on every horizon shorter than 7 years.

In John Hussman’s commentary on May 26, 2014, “Exit Strategy,” he said “The S&P 500 set a marginal new high on Friday, in the context of a broad rollover in momentum thus far this year that we view as likely – though of course not certain – to represent a broad cyclical peak of the sort that we observed in 2000 and 2007, as distinct from spike-peaks like 1987. Valuation measures remain extreme, with the market capitalization of nonfinancial stocks pushing 130% of GDP (relative to a pre-bubble norm of about 55%), the S&P 500 price/revenue ratio at 1.7, versus a pre-bubble norm of 0.8, and the Shiller P/E near 26 – which while lower than the 2000 extreme, exceeds every pre-bubble observation except for a few months approaching the 1929 peak. We presently estimate 10-year nominal total returns for the S&P 500 Index averaging just 2.3% annually, with zero or negative total returns on every horizon shorter than about 7 years.”

In John Hussman’s commentary on June 2, 2014, “Market Peaks are a Process,” he said “It may also be helpful to remember that market peaks are a process, not an event. In the presence of a broad range of reliable valuation metrics uniformly at more than twice their historical norms, coupled with the most severe overvalued, overbought, overbullish, rising-yield syndrome we define, it is instructive how shorter-term action has evolved near those points. Outside of today and 1929, the other two instances are, not surprisingly, 2000 and 2007. The chart below provides a more granular reminder that market peaks are often a broad process and can involve hard initial downturns and swift recoveries. The ultimate follow-through provides some insight regarding the full scale of our concerns”

“I should emphasize that the circled areas on the chart above aren’t chosen arbitrarily but reflect points where similar overvalued, overbought, overbullish extremes were observed. As I’ve noted in recent weeks (see The Journeys of Sisyphus and Exit Strategy), depending on how tightly we define this syndrome the 1972 and 1987 peaks can also be captured among the set of extremes that include 1929, 2000, 2007 and today. Remember that at a fine resolution, the full syndrome sometimes doesn’t precisely align with the final market high. Still, we remain convinced that any near term continuation we observe in this advance is likely to appear quite insignificant in the context of what the market loses over the completion of the cycle.”

“On Friday, our estimate of prospective 10-year S&P nominal total returns set a new low for this cycle, falling below 2.2% annually. This is worse than the level observed at the 2007 market peak, or at any point in history outside of the late-1990's market bubble.”

In all the three 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, or book value etc. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only 1.0-2.2% 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.”

Best Guesses for the Next Two Years:

With the repeated caveat that prudent investors should invest exclusively or nearly exclusively on a multi-year value forecast, my guesses are:

1) That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.

2) But after October 1, the market is likely to be strong, especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.

3) And then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”

“The bull market may come to an end any time, indeed as I write it may already have happened. It could be derailed by disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation, or, perhaps most dangerous and likely, an extreme Chinese slowdown. But I believe it probably (i.e., over 50%) will not end for at least a year or two and probably not before it reaches a level in excess of 2,250 on the S&P 500. Prudent long-term value investors will of course treat all of the above as attempted entertainment (although I believe all statistically accurate) and be prepared once again to prove their discipline and man-hoods (people-hoods) by taking it on the chin. I am not saying that this time is different (attention Edward Chancellor). I am sure it will end badly. But given this regime of the Federal Reserve and given the levels of excess at other market peaks, I think it would be different to end this bull market just yet.”

As of April 30, 2014, GMO’s seven-year forecast is below:

Stocks

     

US Large

-1.2%

Intl Large

0.9%

US Small

-4.6%

Intl Small

0.7%

US High Quality

2.5%

Emerging

4.6%

Bonds

     

US Bonds

0.3%

Inflation Linked Bonds

0.3%

Intl Bonds Hedged

-2.4%

Cash

-0.4%

Emerging Debt

2.2%

   

Other

     

Timber

5.4%

   

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIDw4xLiaGjSyg1VjmkEvuewzDMyuSZO6eBqIGJUpLv7r0Fbqr61%2bnFg2PMcVOE%2btu1vNa5v34Vf8zzjuHfiDaWptpVwcjuZmlVqMmHW6DUnHlgQosMB0S9X

GMO expected US large cap real return is -1.2%. 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 2.5% 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:

1402000546317.png

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 stock market is not cheap as measured by long term valuation ratios. It is positioned for about 1.0-2.2% 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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