The father of value investing, Benjamin Graham, believed that an investor should have an adequate idea of stock-market history, in terms particularly of the major fluctuation in its price level and of the varying relationships between stock prices as a whole and their earnings and dividends, as stated in “The Intelligent Investor.” GuruFocus has plenty of useful tools to help determine the current overall level of the stock market in the “Market” section of the website.
As pointed 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.” At GuruFocus, we have Market-Cap/GDP Valuation available. The valuation compares the total market cap of the Wilshire 5000 Index with the U.S. GDP. As determined by the historic ratio of total market cap over GDP, the market is significantly overvalued and likely to only return 1 percent per year, including dividends, for the next 8 years. The ratio is currently at 123.7 percent. A ratio between 75 and 90 percent indicates a fairly valued market.
The total market cap to GDP is also used to determine projected annual returns in the global markets. Singapore is projected to have an annual return of 16.4 percent, the highest in the developed markets. China is projected to have an annual return of 34.6 percent, the highest in the emerging markets. It is interesting to note that the United States market has the lowest implied return of the 20 global markets that we have valued.
Many people use the P/E ratio as a way to value the market in relation to its earnings. The cyclical nature of earnings and the markets cause the P/E ratio to rise to extraordinary heights during times of recession where earnings are dropping. At the market bottom in March of 2009, the P/E ratio of the S&P 500 was 110.40, clearly indicating that the market was overvalued and should not be bought. Looking back, that was the perfect time to buy. That is why we use the Shiller P/E ratio factoring in the cyclicality of the markets. The Shiller P/E showed that the markets were undervalued at a time when the regular P/E ratio indicated that the markets were extremely overvalued. Howard Marks said the following about cyclicality in his book, “The Most Important Thing.”
- Rule number one: most things will prove to be cyclical.
- Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
The Shiller P/E is calculated by the following:
- Use the annual earnings of the S&P 500 companies over the past 10 years.
- Adjust the past earnings for inflation using CPI; past earnings are adjusted to today's dollars.
- Average the adjusted values for E10.
- The Shiller P/E equals the ratio of the price of the S&P 500 index over E10.
Comparing the current Shiller P/E ratio of 26.2 with its historic mean of 16.6 indicates a significantly overvalued market. The implied future annual return is only 0.8 percent, including dividends, over the next 8 years. The ratio was previously at this level in early 2008, 2000 and 1930.
The Economic Indicators Interactive Chart has nearly 100 indicators to choose from to analyze the markets. The latest addition to the list of indicators is the Chemical Activity Barometer (CAB). The composite index comprises indicators drawn from a range of chemicals and sectors, including chlorine and other alkalies, pigments, plastic resins and other selected basic industrial chemicals. The CAB was added because it has been a reliable leading indicator. A drop in the CAB has preceded every recession by an average of eight months dating back to 1930. Currently the barometer is still climbing higher, so we are in the clear for now.
One of the indicators that we regularly monitor is the Chicago Fed National Financial Conditions Leverage Subindex (NFCI). Positive values of the NCI indicate financial conditions that are tighter than average, while negative values indicate financial conditions that are looser than average. A large spike in the reading typically occurs leading up to a downturn in the markets. The reading is currently at -0.6 and has not yet begun an upward trend.
The indicators mentioned above indicate a market that will continue to rise in the near term, but is expected to have a negative return over the next 8 years when not accounting for dividends. This supports Jeremy Grantham’s guess of where the markets will be heading. He says that historically the markets have been positive in the third year of a presidential term. Therefore, he is expecting 2015 to be positive, with the S&P 500 possibly rallying up to 2,250. He then expects the bubble to pop with the market reverting back to its mean value, likely going back to a Shiller P/E ratio of 16.6.
As mentioned above, there are nearly 100 indicators to choose from to help get an understanding of what level the market is currently at. Other indicators include the Industrial Production Index, Investor Margin Debt, Corporate Profit Margin and Personal Saving Rate and so on. You can also quickly zoom in and out of the charts to get a closer look at any trends you might have discovered.
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