Market Valuations and Expected Returns – April 2, 2015

The market was up more than 30% in 2013, the best year since the go-go years of 1990s. 2014 was another strong year for the market. The S&P 500 index was up more than 13%. Since the market recovery in 2009, the stock market has been up for 6 consecutive years. Yet in January 2015, the stock market benchmark S&P 500 lost 3.10%. In February, the market regained its strength by increasing 5.49%. Throughout March, the market went down by 1.74%. Can the market continue to grow in 2015?

Bernard Baruch once said, “A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.”

George Soros, one of history’s most successful financiers, has been selling US holdings to buy European stocks. It is said that he has moved about $2 billion into companies in Asia and Europe, according to a person familiar with the strategy.

Robert Shiller, who popularized the cyclically adjusted price-to-earnings ratio (commonly known as Shiller P/E), is also thinking about exiting US stocks and getting into Europe. He said in a television appearance on 2/18/2015, “I'm thinking of getting out of the United States somewhat. Europe is so much cheaper.” Specifically, Shiller has already purchased stock indices in Spain and Italy.

Leon Cooperman wrote in an investor letter in January this year remained bullish on the U.S., while predicting bigger gains elsewhere. He said “We expect the European and Japanese equity markets to outperform the U.S. in the coming year.”

In David Tepper’s email to CNBC on 12/23/2014, he said “This year rhymes with 1998. Russia goes bad. Easing coming from Europe. Sets up 1999... I mean 2015. Worldwide money made too easy for where USA fundamentals were in both late 1998 and 2014. What happened in 1999 is not exactly the same but it was similar. The markets are fair value now. But you have to be aware of the possibility for some sort of overvaluation of the markets.”

David Einhorn, the founder and president of Greenlight Capital, is “scaled back wagers on stock gains after markets climbed and as a stronger dollar threatens to limit earnings of U.S. companies from operations overseas,” according to Bloomberg. “Bets on rising assets exceeded short wagers by 38.9 percentage points as of Dec. 31, Greenlight Capital Re Ltd., said in a filing Tuesday. That compares with net-long exposure of 40 percent on Sept. 30 and 53.9 percent at the end of 2013.” “The negatives we see include stretched valuations and earnings headwinds later this year, including a strong dollar, which reduces the translated earnings of foreign subsidiaries,” Einhorn said Wednesday on a conference call discussing the reinsurer’s results. “From a macro perspective, we are worried that emergency policies are now failing.”

In Diamond Hill Capital’s Q4 2014 Market Review, it remained positive but below average long-term outlook for equities:

“Despite the end of the Federal Reserve’s Quantitative Easing, we continue to believe the Fed is likely to maintain a very accommodative overall monetary stance well into next year as the domestic economy is lacking signs of robust growth, while inflation expectations have again turned lower. The recent strength of the U.S. dollar is now playing a key role in these developments as its relative appreciation has created a new headwind for growth while also pushing down commodity prices. The modest deleveraging of the U.S. household sector over the past few years continues to be a positive story. These lower debt levels combined with very low interest rates have allowed consumer debt-service burdens to improve to very low levels by historical standards. This healthy debt service picture remains very much tied to historically low interest/mortgage rates, and any sharp, meaningful increase in those rates is likely to present an important headwind for growth.

Although the U.S. economy appears to be healing at a steady pace and set to maintain its 2% - 3% growth heading into next year, we continue to expect positive but below average equity market returns over the next five years. Our conclusion is primarily based on above average price/earnings multiples applied to already very strong levels of corporate profit margins, which in combination, likely tempers prospective returns. This outlook also seems consistent with the current interest rate environment.”

In David Rolfe’s Wedgewood Partners Q4 2014 Client Letter - '2015 - Groundhog Day or Wizard of Oz?', it mentioned:

“So, as we peer into our cloudy crystal ball for the portents of the stock market in2015, our forecast (murky at best) is largely influenced by the movie Ground Hog’s Day. We can easily envision a scenario much like 2012, 2013 and 2014 - another year of historically low stock price volatility, with full year double-digit gains in the broad stock market indices. This non-rigorous forecast is simply, in our view, driven not explicitly by the economic power and efficacy of the Federal Reserve’s $4.5 trillion quantitatively eased expansion in the Fed’s balance sheet, but rather by the implicit faith investors and speculators have in omnipotent central bankers to ward off the demons of unemployment - and bear markets too.

As we enter 2015 - and as the Great Bull Market reached its sixth anniversary in early March - a review of the current valuation landscape is in order. Please note, while we include neither macro market nor macro economic forecasts into our investment process, we do recognize that “reversion-to-the-mean” is a very powerful element in literally all financial markets, so we do endeavor to comment on such where we feel it is necessary. In our second quarter Letter last year, we highlighted the graphic below, of the Shiller P/E ratio. This ratio is calculated by dividing the S&P 500 Index by a measure of business cycle, smoothed earnings (10-year average of inflation-adjusted earnings). The current ratio of 27X is now at historic extremes – and is now higher than any other period save 1929, 2000 and barely 2007 highs. John Hussman (Trades, Portfolio), CIO at Hussman Funds, propounds that the profit margin currently embedded into the Shiller P/E is 6.7% - versus a historical norm of just 5.4%. With this adjustment considered, the margin-adjusted Shiller P/E of 34X is, in our view, clearly unsustainable - even in consideration of Fed-induced, zero short-term interest rates and a 10-year Treasury rate of sub 2.0%. Furthermore, while the Shiller P/E did average 40X during the months preceding the technology stock bubble 2000, Hussman postulates that the Shiller P/E was then associated with an embedded profit margin of just 5.0%. If one then adjusts for that lower embedded margin then the margin-adjusted Shiller P/E at the 2000 peak was 37X - not much higher than today’s margin-adjusted Shiller P/E of 34.”

In Mario Gabelli’s Asset Fund Q4 2014 Commentary, he said:

“While most signs point towards an improving U.S. economy, certain geopolitical dynamics are concerning. The market’s response to the potential for increased interest rates is also in question. As a result, 2015 could be a volatile year in which we will seek opportunity. Our focus remains on generating superior tax efficient, inflation adjusted returns by relying upon our time tested people, process and Private Market Value (PMV) with a Catalyst philosophy. Our embrace of this philosophy and process has demonstrated superior returns over the history of our firm and we have confidence this should remain the case in the future.”

In John Hussman’s commentary on March 31, 2015, “Eating Our Seed Corn: The causes of U.S. economic stagnation, and the way forward” he said:

“The most reliable stock market valuation measures (i.e. the measures that have a nearly 90% correlation with actual subsequent stock market returns) are those that explicitly take account of the level of profit margins and mute the impact of that variability. These measures suggest that the S&P 500 Index is likely to be lower a decade from now than it is today (though dividend income should bring the total return to about 1.5% annually). Even if the Federal Reserve was to immediately reduce the monetary base by one-third (from nearly 24 cents of monetary base per dollar of GDP to a smaller 16 cents of monetary base per dollar of GDP), short term interest rates would still be zero.”

In GMO Q4 2014 Letter - 'Ditch the Good, Buy the Bad and the Ugly', Ben Inker mentioned:

“Given the backdrop, it is no wonder that the U.S. stock market has been the envy of the world, and with P/Es far from the nosebleed territory of the 2000 bubble, it seems awfully tempting to just follow the advice of the venerable Jack Bogle and avoid non-U.S. stocks entirely. And yet, as the New Year begins, we in Asset Allocation find ourselves slowly selling down even our beloved U.S. quality stocks in favor of the various problem children of the investing world. We are riding away from the Good and into the arms of the Bad and the Ugly. You might chalk it up to sadomasochist tendencies on our part. However, there is a method to our madness.

The short explanation is that markets don’t work quite the way people assume they do. A slightly longer answer is that things that “everybody knows” are generally priced into markets, despite the fact that most of the time what “everybody knows” turns out to be pretty wrong. If you could accurately forecast the surprises, it would be quite helpful, but in the absence of that ability, buying the cheap countries has generally been the right strategy. And the U.S. is about as far from cheap as any country in the world right now. To use one of the better single valuation measures out there, the cyclically adjusted P/E for the U.S. stock market is 26, versus just under 16 for the U.K. and Europe and a little under 14 for emerging. It will take a lot of good economic news to justify that kind of valuation premium in the medium term.”

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.

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 the international market.

Why is this important?

As Warren Buffett pointed out, the percentage of total market cap 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

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 April 2, 2015, the total market cap as measured by Wilshire 5000 index is 124% of the U.S. 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 0.3% a year from this level of valuation, including dividends in the coming years. The stock market is significantly overvalued. As a comparison, at the beginning of 2014, the ratio of total market cap over GDP was 115. Its historical mean is around 85%.

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 March 31, 2014)

As of March 31, 2014, the ratio of Wilshire 5000 over GNP is 1.226.

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.

The prediction from this approach is never an exact number. The return can be as high as 5.2% a year or as low as -7.6% 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 27.1. This is 63.3% higher than the historical mean of 16.6. Implied future annual return is -0.3%. 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:

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 currently estimates nominal total returns of 1.5% annually for the S&P 500 over the coming decade.

In John Hussman’ commentary on March 31, 2015, “Eating Our Seed Corn: The causes of U.S. economic stagnation, and the way forward” he said “The most reliable stock market valuation measures (i.e. the measures that have a nearly 90% correlation with actual subsequent stock market returns) are those that explicitly take account of the level of profit margins and mute the impact of that variability. These measures suggest that the S&P 500 Index is likely to be lower a decade from now than it is today (though dividend income should bring the total return to about 1.5% annually). Even if the Federal Reserve was to immediately reduce the monetary base by one-third (from nearly 24 cents of monetary base per dollar of GDP to a smaller 16 cents of monetary base per dollar of GDP), short term interest rates would still be zero.”

In John Hussman’ commentary on March 23, 2015, “Extremes in Every Pendulum” he said “Whether or not it is fully appreciated, we are observing extremes in nearly every pendulum of the global financial markets. The situation is likely to be seen in hindsight as one of the broadest points of financial distortion in history. Broadest, because unlike the 2000 peak when technology and large capitalization stocks were more overvalued on reliable measures than they are today, the median stock is now more overvalued than in 2000. It’s true that on historically reliable valuation measures that are best correlated with actual subsequent total returns on stocks, the 2000 peak remains the most overvalued point for the S&P 500 in U.S. history, though only about 20% above present valuation levels on those measures (there are certainly many popular but unreliable measures that suggest only moderate overvaluation here). Aside from that 2000 peak, the S&P 500 itself is now more overvalued than at the 1929 peak, not to mention the lesser 1972, 1987 and 2007 extremes. We estimate that the S&P 500 Index is likely to be below its present level a decade from now, though adding dividends is likely to raise the nominal total return to about 1.6% annually on a 10-year horizon.”

In John Hussman’ commentary on March 9, 2015, “What Does That Difference Mean?” he said “We continue to observe one of the most overvalued, overbought, overbullish syndromes in the historical record, combined – and this feature is central – with deterioration in market internals suggestive of a shift toward risk-averse preferences among investors. The resulting combination places current conditions among instances that we identify as a “Who’s Who of Awful times to Invest” (see last week’s comment: Plan to Exit Stocks in the Next 8 Years? Exit Now). Based on historical outcomes associated with those prior instances (which prior to the current market cycle, include only 1929, 1972, 1987, 2000 and 2007), we continue to view the stock market as vulnerable to significant downside risk both in the near-term and over the completion of the present market cycle.”

In all the 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. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only -0.3-1.5% annually in the future years.

Jeremy Grantham’s 7-Year Projection:

In GMO Q4 2014 Letter - 'Ditch the Good, Buy the Bad and the Ugly', Ben Inker said “… And yet, as the New Year begins, we in Asset Allocation find ourselves slowly selling down even our beloved U.S. quality stocks in favor of the various problem children of the investing world. We are riding away from the Good and into the arms of the Bad and the Ugly. You might chalk it up to sadomasochist tendencies on our part. However, there is a method to our madness. … And the U.S. is about as far from cheap as any country in the world right now. To use one of the better single valuation measures out there, the cyclically adjusted P/E for the U.S. stock market is 26, versus just under 16 for the U.K. and Europe and a little under 14 for emerging. It will take a lot of good economic news to justify that kind of valuation premium in the medium term.”

As of February 28, 2015, GMO’s 7-year forecast is below:

Source:

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIDqLlslDnruR1Di4gefx3gvDWPmVRTjt93Fntec6wZQAbTLPh9QXbvITQWBEDIuTn6uid3ZZjOmjvyef42PhTcHlR3LagL%2fp6kzwfTvHyS27A%3d%3d

GMO expected US large cap real return is -2.4%. 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 only -0.1% 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:

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.

Tobin’s Q

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. He hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs.

The following graph is Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1950.

The GuruFocus Economic Indicator Tobin Q page indicates that the Q ratio is 1.10 as of October 1, 2014. This is 54.9% higher than the historical mean of 0.71. Latest Q ratio is now the second highest in history, just following the peak of the Tech Bubble.

If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. The market may be overvaluing the company.

S&P 500 Quarterly Buybacks

The GuruFocus Economic Indicator S&P 500 Quarterly Buybacks page indicates that the preliminary S&P 500 quarter buybacks is $145.19 billion as of September 30, 2014. According to S&P Dow Jones Indices press release, “that preliminary results show that S&P 500 third quarter 2014 stock buybacks, or share repurchases, increased 25.0% to $145.2 billion up from the $116.2 billion spent on share repurchases during the second quarter of this year. The $145.2 billion Q3 spend represents a 13.3% increase from the $128.2 billion spent during the third quarter of 2013. Share count reductions continue to add a tailwind to EPS, says Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices. While third quarter expenditures were up 25%, the number of companies reducing their share count declined 13%. Still, over half of the S&P 500 issues reduced their share count with 20% decreasing them enough to impact their year-over-year EPS by at least 4%.” 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.

The following chart is the S&P 500 quarterly buybacks since 2000 to present.

Conclusion: The stock market is not cheap as measured by long term valuation ratios. It is positioned for about -0.3-1.5% 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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