The market had its worst January in many years. This has generated quite some fear in the market and has prompted Howard Marks (Trades, Portfolio) written two memos in January: On the Coach and What Does the Market Know? We strongly recommend you to read both if you haven’t done so.
Regarding to market valuations, we agree with what Steven Romick (Trades, Portfolio) said in his latest quarterly commentary:
We’ve been arguing for some time that the market isn’t cheap and, even with the broad stock market averages having declined in 2015, it’s not like businesses are being given away. Take the U.S., for example, and compare the trailing median Price/Earnings (P/E), Price/Sales (P/S) and Price/Book (P/B) ratios on December 31 to the month-end of the two prior market peaks. The P/E and P/B ratios are in line with past peaks while the P/S is as high as it has ever been. No bargains here.
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 GNP. As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US 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 108.1%, down from 114.3% at the beginning of January. If we assume the ratio will revert to the mean in 8 years, the market will average 1.8% of return over the next 8 years, including dividends.
This seems very pessimistic. But the ratio has been quite 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 it is historical mean in 8 years, while the red line is the extreme optimistic case, which gives a potential return of 6.89% a year over the next 8 years. The green line is the pessimistic case, which gives an return of -6.2% a year over the next years. The yellow line is the actually return, which has pretty good agreement with the blue line.
For more details of Buffett indicator and how we arrived at these numbers, please visitor Where Are We with Market Valuations?
Shiller P/E Ratio and Its Predictions
Shiller P/E, named after its invention Prof. Robert Shiller of Yale University, is another more objective measurement of the market valuation. As of today, it sits at 24.2, down from 25.3 at the beginning of January, which is about 44.9% higher than the historical mean of 16.7.
This is the historical value of Shiller P/E:
Shiller P/E certainly indicates that the market is wildly overvalued. Historically only three periods the ratio was higher, the bubble of 1929, the tech bubble of 1999 and the financial bubble of 2007. The regular P/E is 21, which is also much higher 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 0.3% a year over the next 8 years, which is similar to the conclusion we reached from the Buffett indicator.
To learn more about Shiller P/E, please go here.
Insider Trends
Insider trends ars a great indicator of what insiders are thinking about the valuations. You can learn more about insider trends here.
In January, insiders were not as bullish as they were back in December, although the stock prices are lower.
Sector/Industry Valuation
The poor performance of energy sector has driven the valuation of energy companies to the lowest in market, as shown in GuruFocus page of Industry Overview. The median P/E of the sector is now 5.7 for oil & gas drillers, and 9.2 for E&P companies. As the consequence, the median dividend yields of these companies are now above 5.44%.
Being out of favor like this, patient investors may be able to find some real bargains. The companies with good dividend coverage are good bets for income investors, too.
Among all sectors, the most expensive ones are biotech and online media. The median P/E in these industries is above 33, and the dividend yields are less than 2%.
You can see the sector/industry valuation distribution in GuruFocus page of Industry Overview: Valuation, Dividend Yield, Growth and Profitability
Model Portfolios
GuruFocus Most Broadly Held Portfolio continues to outperform the market. As of Feb. 2, the market was down 6.89%, while the portfolio is down 5.37%. This portfolio has outperformed the market in 8 out of the 10 years since inception. The portfolio has a turnover of less than 25%. The portfolio owns stocks like Alphabet (GOOG), Johnson & Johnson (JNJ), and Wal-Mart (WMT). They have contributed positively to the portfolio performance.
If you want to invest in this portfolio, please look at this DIY guide.
Junk Bond Yield Keeps Rising
There are warning signs in the bond market. The junk bond has been rising. The yield is now its highest level in 6 years. Since 1997, there were only two occasions that had higher junk bond yields, and both were associated with recessions. This is something investors should keep an eye on. For historical yields, please look at the chart below: