With a total market cap/gross domestic product ratio of 119.4%, the stock market is significantly overvalued as of July 1. Based on the following review of market valuations and expected future returns, Warren Buffett (Trades, Portfolio) suggests investing in high quality companies at undervalued prices.
Buffett’s indicator for market valuation
Buffett pointed out that the total market cap/gross national product ratio, the Buffett indicator, is “probably the best single measure of where valuations stand at any given moment.” As of July 1, the Wilshire Total Market index is worth $21.76 trillion, about $200 billion greater than its value June 2. Assuming that the market reverts to the mean in eight years, the market will average a meager 40 basis points (0.40%), including dividends, during the eight-year period.
While the average return of 0.40% sounds pessimistic, the returns are not as bad as predicted. The Predicted and Actual Stock Market Returns chart presents four lines: three lines based on TMC/GDP predictions and the fourth line based on actual returns.
The red, blue and green lines show the extreme optimistic, revert to the mean and the extreme pessimistic cases. In the very optimistic case, the expected annual return for next eight years is 5.4%, and in the very pessimistic case, the expected annual return is -7.5%. The actual returns have generally matched up with the blue line, which graphs the expected market return if the market reverts to the mean. This suggests that future returns will be similar to the expected returns based on a expected TMV/GDP of 80%.
Shiller’s indicator for market valuation
Yale University professor Robert Shiller invented a more objective version of the standard P/E ratio. Since this ratio eliminates fluctuations due to profit margin variation, the Shiller P/E ratio more reasonably values the market than the regular P/E ratio. As of July 1, the stock market is significantly overvalued based on its Shiller P/E; the market’s current Shiller P/E of 26.3 is 57.5% higher than the market’s historic mean of 16.7. This suggests an implied future annual return of -0.2% for the next eight years, slightly worse than the 0.40% return suggested by Buffett’s indicator.
Insider trends: more sells than buys
Insiders have generally been bearish on the stock market with a buy/sell ratio of just 0.48 as of June. The only time in 2016 that insiders were slightly bullish on the market was in January with a buy/sell ratio of 1.12. Additionally, CEOs have been bearish on the stock market since September 2015, the last time their buy/sell ratio surpassed 1.00. As mentioned in the market valuation article for June, the best time to buy according to insiders was right after major U.S. recessions like the 2008 financial crisis.
Energy sectors have low median Shiller P/Es but high dividend yields
As of July 1, companies in oil and gas industries have relatively low P/E and Shiller P/E ratios. Drilling companies have the lowest Shiller P/E ratios, with a median of just 6.64. These low ratios are likely due to relatively low oil prices. While oil prices have recently increased, they are still near 10-year lows. Today, oil traded around $45.80 a barrel.
On the bright side, oil and gas companies have high dividend yields; midstream companies have a median dividend yield of 6.72% while integrated companies have a median dividend yield of 5.98%.
Corporate profit margins recover only slightly
While the post-tax corporate profit margins have recovered slightly, the profit margins are still near five-year lows. As corporate profit margins continue to decline, the market may go into a recession in the coming years.
Conclusions
With the above market valuations, the stock market is highly overvalued and has potential to go into recession. Based on these market valuations, Buffett suggests investing in stocks that are undervalued, predictable and have high quality business operations. Even during recessions, the Buffett-Munger model portfolio has generally outperformed the market. Stocks that are potential buys when the market is significantly overvalued can be found in the Buffett-Munger screener.
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