GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Market Valuations and Expected Returns - July 2, 2014

July 02, 2014
Vera Yuan

Vera Yuan

85 followers

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. In May, the market gained 2.10% and in June, the market benchmark S&P 500 went up 1.91%. The market continuously hit the record high. The close price of S&P 500 was 1973.32 on July 1, 2014.

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 Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham stated out “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 June 23, 2014, “This Time is Different, Yet with the Same Ending,” he said “the best we can do here is to choose one of two courses: a) speculate that valuations will move still higher, waiting not only for 7-year but 10-year prospective returns to go negative, understanding that those dismal long-term returns will still emerge, but hoping that we can eke out some gains before the well runs dry and we’re forced to beat millions of other speculators to the door, or b) maintain a defensive stance, recognize that equity risk taken at present levels is likely to produce negative returns on horizons of 7 years and less, and that a 10-year expected annual nominal total return of 1.9% for the S&P 500 is not worth the commensurate risk, but adapt to a world of flying pigs by allowing them to float a bit more freely without raising the safety nets further. Our choice would be b).

Professor Robert Shiller said on June 25, 2014 that “I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

Quoted from CNBC, David Tepper, the head of Appaloosa Management told a few thousand of his colleagues on May 14 at SkyBridge Capital's SALT 2014 conference in Las Vegas that “I'm not saying go short, I'm just saying don't be too frisking long right now.” “Now I have a position (where) I'm long enough with exposure where I can bring it up or I can take it down," Tepper said. "I am nervous. I think it's nervous time.” Tepper later told CNBC he has reduced his equity exposure to about 60 percent from 100 percent six months ago, but that he still sees value in stocks like Google (GOOGL) and Priceline (PCLN).

Quoted from Bloomberg, global money managers raised cash holdings to a two-year high in May and say America is the worst place to invest, a Bank of America Corp. survey published in May shows. Funds held an average 5 percent in cash, according to the survey, which was conducted during the week through May 8. According to data compiled by Bloomberg and the Investment Company Institute, investors have pulled about $10 billion from funds that buy U.S. equity in May, set for the biggest outflows since August, 2013.

After embracing stocks last year for the first time since the bull market began, individuals are showing signs of reverting to the skepticism that led them to pull more than $400 billion from mutual funds from 2009 through 2012. While hedge fund manager David Tepper says caution is appropriate now, others consider the lack of exuberance a healthy sign that sets the stage for more gains.

“When you see this type of downdraft in very visible names, people’s risk averse attitude tends to take over,” Margie Patel, who oversees about $1.4 billion at Wells Capital Management in Boston, said by phone on May 15. “After the economic crisis, a lot of investors were traumatized. People are more looking at preserving their assets.”

“Walls of worry are everywhere,” Robert Doll, who helps oversee $118 billion as chief equity strategist at Nuveen Asset Management in Chicago, told Tom Keene and Michael McKee on Bloomberg Radio’s “Surveillance” on May 14. “This is the least believed bull market that I’ve ever seen. From here it’s earnings, it’s fundamentals, it’s can the economy grow? And my guess is the answer to that question is yes.”

According to TrimTabs Investment Research’s CEO David Santschi, buyback announcements have fallen to $92.7 billion in the quarter from $138.5 billion in the first quarter. And for the month of June, buybacks have fallen to just $11.5 billion, the lowest monthly level since May of 2012. “The sharp slowdown in buybacks is a negative sign for the U.S. stock market,” Santschi said. “Share repurchases are the main way companies reduce the float of shares. Perhaps fewer companies like what they see when they look into the future.” Santschi acknowledged that “while the bull market isn’t necessarily ending, investors should be more cautious on the long side.” The following chart is the quarterly shareholder distribution from buybacks and dividends since 2005 to present.

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

1404328883033.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 July 2, 2014, the total market cap as measured by Wilshire 5000 index is 123.5% 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 1.0% 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 30, 2014)

1404328993617.png

As of June 30, 2014, the ratio of Wilshire 5000 over GNP is 1.208.

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.

1404329052944.png

The prediction from this approach is never an exact number. The return can be as high as 5.9% a year or as low as -6.8% 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 26.3. This is 59.4% higher than the historical mean of 16.5. Implied future annual return is 0.6%. 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:

1404329317729.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 nominal total returns averaging just 1.9% annually, with negative expected total returns on every horizon shorter than 7 years.

In John Hussman’s commentary on June 30, 2014, “The Delusion of Perpetual Motion,” he said “based on valuation measures most reliably associated with actual subsequent market returns, we presently estimate negative total returns for the S&P 500 on every horizon of 7 years and less, with 10-year nominal total returns averaging just 1.9% annually. I should note that in real-time, the same valuation approach allowed us to identify the 2000 and 2007 extremes, provided latitude for us to shift to a constructive stance near the start of the intervening bull market in 2003, and indicated the shift to undervaluation in late-2008 and 2009.”

In John Hussman’s commentary on June 23, 2014, “This Time is Different, Yet with the Same Ending,” he said “the best we can do here is to choose one of two courses: a) speculate that valuations will move still higher, waiting not only for 7-year but 10-year prospective returns to go negative, understanding that those dismal long-term returns will still emerge, but hoping that we can eke out some gains before the well runs dry and we’re forced to beat millions of other speculators to the door, or b) maintain a defensive stance, recognize that equity risk taken at present levels is likely to produce negative returns on horizons of 7 years and less, and that a 10-year expected annual nominal total return of 1.9% for the S&P 500 is not worth the commensurate risk, but adapt to a world of flying pigs by allowing them to float a bit more freely without raising the safety nets further. Our choice would be b).”

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 0.6-1.9% 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 May 31, 2014, GMO’s 7-year forecast is below:

Stocks

US Large

-1.5%

Intl Large

0.9%

US Small

-4.5%

Intl Small

0.4%

US High Quality

2.3%

Emerging

4.4%

Bonds

US Bonds

-0.1%

Inflation Linked Bonds

-0.2%

Intl Bonds Hedged

-2.5%

Cash

-0.4%

Emerging Debt

1.6%

Other

Timber

5.4%

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBZ8qXgYuM1CIQAkR3ao5gWsOoJbZRA87AWmfEO7HQmrVbMxbQNlDH2t4GbPUG7HZyQKgZeX%2fCeu7z8rGHnuXHJJiu2tSpQgNgPgyfELR90lr2nhrkIx1dH

GMO expected US large cap real return is -1.5%. 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 2.3% 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 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:

1404333595943.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 0.6-1.9% 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.

If you are not a Premium Member, we invite you for a 7-day Free Trial.


Rating: 5.0/5 (9 votes)

Voters:

Comments

ecotycoon
Ecotycoon premium member - 3 months ago

"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."

Seem like people forget fast, once again great article, thanks for sharing the Robert Shiller link,

John Emerson
John Emerson - 3 months ago

Thank you Vera for providing regular updates on overall market valuations. It should also be noted that the Q ratio is also at its historical high point with the exception of a brief period during the tail end of the internet bubble. The ratio measures the total market value of a businesses divided by their replacement value, similar to a price to book ratio.

Anyone who has done any stock research recently is well aware of the fact that the price of most stocks are trending towards the top end of their historical valuation metrics. Personally, my cash position after paying substantial taxes is closing in on 50%. Not a conscience decision to raise cash, rather an inability to locate equities which possess a sufficient margin of safety to merit an investment.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK