Time flies, and it is now less than a month to the end of the year. The market is up by low single digits, and we would like to review where we are with the market and some of our observations.
Market valuations as measured by the Buffett indicator
The most important indicator of the stock market valuation is what we called Buffett indicator. It is the ratio of total market cap over gross national product (GNP). 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.”
This the historical value of the ratio:
As of today, the ratio is standing at 122.1%. If we assume the ratio will revert to the mean in eight years, the market will average exactly 0% of return over the next eight years, including dividends.
This seems pessimistic. But the ratio has been accurate in predicting long-term market returns as indicated in the chart below:
The blue line in the above chart is the prediction based on the ratio of Total Market Cap over GNP will be its historical mean in eight years, while the red line is the extreme optimistic case, which gives a potential return of 5% a year over the next eight years. The green line is the pessimistic case, which gives a return of -7.8% a year. The yellow line is the actual return, which has pretty good agreement with the blue line.
For more details of the Buffett indicator and how we arrived at these numbers, please visit Where Are We with Market Valuations?
Shiller P/E ratio and its predictions
Shiller P/E, named after its inventor, professor Robert Shiller of Yale University, is another more objective measurement of the market valuation. As of today, it sits at 26.6, which is about 60% higher than the historical mean of 16.7.
This is the historical value of Shiller P/E:
Shiller P/E also indicates that the market is wildly overvalued. Historically in only three periods was the ratio higher –Â the bubble of 1929, the tech bubble of 1999 and the financial bubble of 2007. The regular P/E is22, which is also much higher than the historical mean of 15.9.
We can use the similar revert to the mean methodology to calculate potential market returns. At today’s Shiller P/E, the market is likely to return -0.5%Â per year over the next eight years, which is similar to the conclusion we reached from the Buffett indicator.
To learn more about Shiller P/E, please go here.
Growth vs. value
Value investors have been underperforming over the past several years. It may be time for value stocks to outperform, according to Yacktman Fund. By the way, Donald Yacktman (Trades, Portfolio), the firm’s founder, will be our keynote speaker at next year’s GuruFocus Value Conference. The conference is now open for early registration. Register now for a discounted ticket.
According to Yacktman Fund (Trades, Portfolio):
"The broader stock market continues to be two-tiered with high-priced growth stocks generally outperforming value. This phenomenon also occurred in the late 1990s. In that market environment, we shifted assets into temporarily underperforming securities, setting up the Fund for superior results in the ensuing years. The prospects for economic and earnings growth are more challenging than in the last several years, an environment we think bodes well for high quality (which we strongly favor) over low quality.
"Year to date, the Russell 1000® Growth Index has outperformed the Russell 1000® Value Index by more than 700 basis points.
"Investors should be careful about piling into what has worked well in a long-running, highly valued bull market. We feel it is more prudent to focus instead on investments that represent long-term value."
Insider trends
Insider trends is a great indicator of what insiders are thinking about the valuations. You can learn more about insider trends here.
As indicated below, insiders are less enthusiastic about their stocks than they were in the previous month.
Insider Trend: Overall
Insider Trend: Consumer Defensive
Insider Trend: Health care
The insiders in consumer defensive and health care are buying more of their own stocks than normal. These sectors might be places for bargains. You can check out the details of the insider buys in Healthcare and Consumer Defensive.
Junk bond yield is rising
There are warning signs in the bond market. The junk bond has been rising. The yield is now its highest level in six years. This is something investors should keep an eye on. For historical yields, please look at the chart below:
Standard & Poor's 500 earnings declined
Another warning sign is that the earnings of S&P 500 companies are declining. The last time it started its declining trend was 2007, right before the bull market ended:
Thank you for reading. Again GuruFocus' Value Conference is now open for early registration. Register now for a discounted ticket.
