September has historically been a tough month for the market, and this past month was no exception. In particular, the last day of the month is often one of the worst days of the year for the market. According to research from Bespoke, the Standard & Poor's 500 has only had positive returns 38% of the time on Sept. 30 dating back to 1945.
For the last week of September, the S&P 500 was down 2.3%, the second-worst week of the year so far since the August selloff. CNBC reported that the global markets were set to post their worst quarterly performance since 2011, with the Shanghai Composite as the lowest performer, with a 25% loss.
One factor affecting the U.S. market was uncertainty over whether the Federal Reserve would raise interest rates for the first time in nine years at its September meeting. But on Sept. 17, Fed Chairwoman Janet Yellen and eight other committee members voted to maintain rates at 0% to 0.25%.
Chuck Royce (Trades, Portfolio) expressed his disappointment in the decision, saying the current solid GDP growth allows the Fed to safely end its interventionist policies.
“We were also disappointed by Fed Chair Janet Yellen's reasons, particularly those that dwelled on the slowdown in China as part of the rationale for not raising rates,” Royce said.
Royce also said he believes the market is entering a correction rather than a bear market, and predicted the correction would be no more than 15%. The downturn is motivated by an overblown fear of the global slowdown rather than weakness in the economy or contraction in earnings, he said.
GuruFocus offers several features to help investors analyze market valuations. One features the market valuation based on the ratio of total market cap over GNP, which Warren Buffett (Trades, Portfolio) has said is “probably the best single measure of where valuations stand at any given moment.”
As of today, the total market index is 114.2% of the last reported GDP, positioning the market for an average annualized return of 0.9%. Based on this, GuruFocus estimates the market is modestly overvalued.
The source of investment returns are determined by three factors: business growth, dividends, and change in the market valuation. Using these factors, the return of an investment can be estimated by the following formula:
Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
The third variable in the equation can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated as:
(Re/Rb)(1/T)-1
Therefore, the investment return equation is equal to:
Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1
In GuruFocus’ calculations, the time period used is eight years, as this is about the length of a full economic cycle. The yellow line in the graph below depicts the actual annualized return of the market over eight years, using the Wilshire 5000 Full Cap Price Index. The green line shows expected returns if the market is undervalued over the next eight years (TMC/GNP=40%), the red line indicates returns if the market is overvalued (TMC/GNP=120%), and the blue line shows expected returns if the market trends toward fairly valued (TMC/GNP=80%).
Another market valuation indicator is the Shiller P/E invented by Yale economist Robert Shiller, which eliminates fluctuation of the ratio caused by profit margin variations during business cycles. As of today, the Shiller P/E is 24.8, 49.4% higher than the historical mean of 16.6.
According to famed investor and Magic Formula inventor Joel Greenblatt (Trades, Portfolio), an important development for market participants is the return to an appreciation for risk.
In Gotham Funds’ Sept. 1 letter, Greenblatt writes that the Russell 1000 and Russell 2000 have been cheaper 62% and 87% of the time over the firm’s 25-year research history. Based on this, the year forward return of the Russell 1000 has been 6% to 11%, while it is 1% to 2% for the Russell 2000.
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