October is not known as a month for strong market returns, but investors got a reprieve last month as returns were some of the best in the past four years.
The DJIA gained 8.5%, its best performance since October 2011, while the S&P 500 was up 8.3%, the best monthly return in four years. Small-caps lagged behind, but the Russell 2000 still posted a 5.9% gain for the month.
Despite the better-than-expected performance for the market, many big-name hedge funds posted wide losses. Bill Ackman (Trades, Portfolio)’s Pershing Square’s net performance declined 7.3% in October, and is now down 19% for the year, according to the firm’s monthly performance report. Larry Robbins (Trades, Portfolio)’ Glenview Capital was down 7.3% through Oct. 26, with a 20.25% loss year-to-date.
On the other hand, Greenlight Capital led by David Einhorn (Trades, Portfolio) returned 0.7% for the month, though it is still down 16.3% for the year.
In his third quarter letter, Dan Loeb of Third Point wrote that he remained optimistic of the fund’s current holdings, which include event-driven names and structured credit, despite his many concerns in the current environment such as a struggling China, recent employment weakness in the U.S. and deeply divided politicians on both sides of the aisle.
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 called one of the best measures of where valuations stand at any given moment.
As of today, GuruFocus estimates the market is significantly overvalued, with the ratio of total market cap over GDP at 122.1%.
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 26.5, 59.6% higher than the historical mean of 16.6.
Looking forward, small-cap guru Chuck Royce has said that while there are many weaknesses currently present in the energy sector, homebuilding is booming, as well as other sectors outside of energy and industrial.
In the third quarter commentary for the Yacktman Focused Fund (Trades, Portfolio), Donald Yacktman (Trades, Portfolio) wrote that he believes the current market is similar to the late 1990s, near the end of an expensive and long-running bull market. Still, investors know well that it’s difficult to predict the market, and time will tell whether the market will continue on the current trajectory.
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