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%. In April, the market was up by 0.85%. 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 Bill Frels’ Mairs & Power Balanced Fund Q4 2014 Commentary, he expected positive but muted equity returns for this year:
“We expect interest rates to begin rising sometime in 2015 which will have several effects that bear watching. We do not believe that a slight increase in rates would, by itself, end the current cycle. However, the advantage stocks have enjoyed over fixed income securities in the current low interest rate environment will be lessened as rates rise and investors find more places that offer yield.
The rate of growth for both revenue and earnings among small and large companies continues to be impressive. Furthermore, we believe that low energy prices will continue to benefit the U.S. economy over the next several quarters. When we look at the U.S. economy, we see no significant weaknesses. With the current cycle entering its seventh year and price to earnings ratios above their historic averages, we can expect positive, but muted equity returns for this year.”
In Dodge & Cox’ Stock Fund Q1 2015 Commentary, it mentioned:
“U.S. equity markets continued to rise during the first quarter: the S&P 500 posted its ninth consecutive quarter of gains. Interest rates remained low in the United States and around the world. Oil prices continued to decline, which aided U.S. household purchasing power. In the United States, labor market conditions improved, evidenced by lower unemployment and job gains, and businesses invested more in fixed assets. Despite these positive economic developments, overall U.S. economic growth moderated slightly as the recovery in the housing sector remained slow and export growth weakened. The U.S. dollar continued to strengthen (e.g., up 13% versus the euro during the quarter), which devalued the foreign earnings of large, U.S.-based multinational firms.
We believe U.S. equity market valuations are reasonable, although they have increased and are above the long-term average. The S&P 500 traded at 17.5 times forward estimated earnings with a 2.0% dividend yield at quarter end. Corporate balance sheets and cash flows continue to be strong despite modest earnings growth expectations for 2015. We continue to have a positive, albeit more modest, outlook for equities over our three- to five-year investment horizon and remain optimistic about the long-term prospects for corporate sales growth and earnings growth. In our opinion, the Fund’s portfolio is well positioned to benefit from long-term global growth opportunities. Acknowledging that markets can be volatile in the short term, we encourage shareholders to remain focused on the long term.”
In Brian Rogers’ T Rowe Price Equity Income Fund Q1 2015 Commentary, he remained cautious for the stock market:
“Our outlook for the stock market remains cautious. While we should continue to see reasonable economic and earnings growth, it has become more challenging to find attractively valued investment opportunities. Outside the U.S., many economies face numerous macroeconomic headwinds. We expect reasonable economic and earnings growth in 2015 albeit with more volatility than we have experienced in recent years. While prices in most areas of the stock market have reached a level where finding value is difficult, we have recently found opportunities in a few companies that have not fully participated in the market rally. These include consumer-focused companies, energy companies, and financial companies trading at relatively attractive valuations.”
In John Hussman’ commentary on March 31, 2015, “The "New Era" is an Old Story” he said:
“Our view is simple. The U.S. stock market is in the third valuation bubble of the past 15 years, which is likely to be resolved by losses similar to the outcomes we observed in the first two. In short, given currently extreme valuations, the most historically reliable valuation methods instruct us to expect total returns of roughly zero for the S&P 500 over the coming decade. If one believes that depressed interest rates “justify” obscene valuations and associated expected returns of roughly zero for the S&P 500 over the next 10 years, then one is quite free to call stocks “fairly valued” – it’s just that those “fairly valued” stocks are still likely to go nowhere over the coming decade, with some spectacular interim losses along the way.”
In GMO Q1 2015 Letter - 'Are We The Stranded Asset?', Jeremy Grantham mentioned:
“A brief update on the U.S. market: still not bubbling yet, but I think it will
To remind you, we at GMO still believe that bubble territory for the S&P 500 is about 2250 on our traditional assumption that a two-sigma event, based on historical price data only, is a good definition of a bubble. (As we like to describe it, arbitrary but reasonable, for it fits the historical patterns nicely.)
For the record, probably the best two measures of market value – Shiller P/E and Tobin’s Q – have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively. So, just as with the price-only series, they are also well on the way to bubble-dom but, clearly enough, not there yet. If we used these value series instead of just price it would add 5-10% to the bubble threshold, further improving my case that the current market still has a way to go before reaching bubble territory. Historically, we have often used the price series as both less judgmental than using measures of value, and as a much fairer comparison with other bubbles (e.g., commodities currencies and housing).
We could easily, of course, have a normal, modest bear market, down 10-20%, given all of the global troubles we have. If we do, then the odds of this super-cycle bull market lasting until the election would go from pretty good to even better. So, “2250, here we come” is still my view of the most likely track, but foreign markets are of course to be preferred if you believe our numbers. Stay tuned.”
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 May 19, 2015, the total market cap as measured by Wilshire 5000 index is 126.5% 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% 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, 2015)
As of March 31, 2015, 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 4.9% a year or as low as -7.8% 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 27.4. This is 65.1% higher than the historical mean of 16.6. Implied future annual return is -0.5%. 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 roughly 0% annually for the S&P 500 over the coming decade.
In John Hussman’ commentary on May 18, 2015, “The "New Era" is an Old Story” he said “Our view is simple. The U.S. stock market is in the third valuation bubble of the past 15 years, which is likely to be resolved by losses similar to the outcomes we observed in the first two. In short, given currently extreme valuations, the most historically reliable valuation methods instruct us to expect total returns of roughly zero for the S&P 500 over the coming decade. If one believes that depressed interest rates “justify” obscene valuations and associated expected returns of roughly zero for the S&P 500 over the next 10 years, then one is quite free to call stocks “fairly valued” – it’s just that those “fairly valued” stocks are still likely to go nowhere over the coming decade, with some spectacular interim losses along the way.”
In John Hussman’ commentary on May 4, 2015, “Two Point Three Sigmas Above the Norm” he said “One of the things that may slightly comfort investors here is Jeremy Grantham (Trades, Portfolio)’s recent observation that while the Shiller P/E and Tobin’s Q are 1.5 and 1.8 standard deviations above their long-term averages, respectively, they are not yet overvalued by “two sigmas.” Now, I respect Grantham more than virtually anyone else in the investment world, but I also believe that these figures understate current extremes for several reasons I’ll detail below. I’ll summarize our own assessment first. Based on the most reliable valuation measures we identify, stock market valuations are already 2.3 sigmas above reliable historical norms. For our part, we think a decade is quite a long-time to assume away any event that would provoke investors to demand something close to a normal, run-of-the-mill 10% prospective market return at some point in that decade. Even in depressed interest rate environments, prospective equity returns tend to be weakly correlated with interest rates and rate movements (and are often negatively correlated). The only span in history where the correlation was clearly positive was during the inflation-disinflation cycle from the mid-1960’s to the mid-1990’s. If you’re waiting for stocks to become overvalued by 2 standard deviations, we’re already past that, and we would not be at all surprised to observe another decade of negative total returns on the S&P 500, as we observed the last time valuations were similar on the most reliable measures.”
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 -0.5-0% annually in the future years.
Jeremy Grantham’s 7-Year Projection:
In GMO Q1 2015 Letter - 'Are We The Stranded Asset?', Jeremy Grantham said as I quote:
“A brief update on the U.S. market: still not bubbling yet, but I think it will
1: The key point here is that in our strange, manipulated world, as long as the Fed is on the side of a strong market there is considerable hope for the bulls. In the Greenspan/Bernanke/Yellen Era, the Fed historically did not stop its asset price pushing until fully-fledged bubbles had occurred, as they did in U.S. growth stocks in 2000 and in U.S. housing in 2006. Both of these were in fact stunning three-sigma events, by far the biggest equity bubble and housing bubble in U.S. history. Yellen, like both of her predecessors, has bragged about the Fed’s role in pushing up asset prices in order to get a wealth effect. Thus far, she seems to also share their view on feeling no responsibility to interfere with any asset bubble that may form. For me, recognizing the power of the Fed to move assets (although desperately limited power to boost the economy), it seems logical to assume that absent a major international economic accident, the current Fed is bound and determined to continue stimulating asset prices until we once again have a fully-fledged bubble. And we are not there yet.
2: To remind you, we at GMO still believe that bubble territory for the S&P 500 is about 2250 on our traditional assumption that a two-sigma event, based on historical price data only, is a good definition of a bubble. (As we like to describe it, arbitrary but reasonable, for it fits the historical patterns nicely.)
3: For the record, probably the best two measures of market value – Shiller P/E and Tobin’s Q – have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively. So, just as with the price-only series, they are also well on the way to bubble-dom but, clearly enough, not there yet. If we used these value series instead of just price it would add 5-10% to the bubble threshold, further improving my case that the current market still has a way to go before reaching bubble territory. Historically, we have often used the price series as both less judgmental than using measures of value, and as a much fairer comparison with other bubbles (e.g., commodities currencies and housing).
4. We could easily, of course, have a normal, modest bear market, down 10-20%, given all of the global troubles we have. If we do, then the odds of this super-cycle bull market lasting until the election would go from pretty good to even better. So, “2250, here we come” is still my view of the most likely track, but foreign markets are of course to be preferred if you believe our numbers. Stay tuned.”
As of April 30, 2015, GMO’s 7-year forecast is below:
| Stocks | Â | Â | Â |
| US Large | -2.1% | Intl Large | -0.4% |
| US Small | -2.9% | Intl Small | -0.8% |
| US High Quality | 0.6% | Emerging | 2.4% |
| Bonds | Â | Â | Â |
| US Bonds | -1.0% | Inflation Linked Bonds | -0.6% |
| Intl Bonds Hedged | -3.5% | Cash | -0.3% |
| Emerging Debt | 2.1% | Â | Â |
| Other | Â | Â | Â |
| Timber | 4.8% | Â | Â |
GMO expected US large cap real return is -2.1%. This number is similar 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 0.6% 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 $132.63 billion as of December 31, 2014. According to S&P Dow Jones Indices press release, “S&P 500 fourth quarter 2014 stock buybacks, or share repurchases, decreased 8.7% to $132.6 billion down from the $145.2 billion spent on share repurchases during the third quarter of this year. The $132.6 billion Q4 spend represents a 2.5% increase from the $129.4 billion spent during the fourth quarter of 2013. For the fiscal year 2014, S&P 500 issues increased their buyback expenditures by 16.3% to $553.3 billion from $475.6 billion posted in 2013. The high mark was reached in 2007, when companies spent $589.1 billon. The recession low point was $137.6 billion, recorded in 2009.”
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 -0.5-0% 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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