As mentioned in the previous article, the stock market has been significantly overvalued as of July 1. However, the valuation continued to increase throughout July. As of July 29, the total market cap/gross domestic product ratio reached 123.5%, about 4% higher than the ratio as of July 1. Based on the current TMC/GDP ratio, the stock market is expected to average -0.1% per year for the next eight years.
Buffett’s market indicator predicts negative returns
Warren Buffett (Trades, Portfolio) claims that the TMC/GDP ratio best determines the current valuation of the market. The higher the total market cap is relative to the gross domestic product, the more overvalued the market is and the higher likelihood of a recession. As the total market cap increased about $500 billion during July, the expected market rate of return dropped below zero. Assuming that the market reverts to the mean, the average annual market return for the next eight years is negative 10 basis points (-0.1%) as of July 29.
Based on the predicted and actual returns chart, the actual returns still follow the blue trendline that assumes a TMC/GDP ratio of 80%. In the extremely optimistic case, labeled red, the average annual return is about 4.9%, about 60 basis points lower than the expected average annual return as of July 1. The green trendline, which highlights the extremely pessimistic case, expects an average annual return of -7.9%.
Shiller P/E determines the sectors to invest and those to avoid
The Shiller price-to-earnings ratio generally provides a more reasonable market valuation than the regular P/E since Shiller’s P/E removes the volatility caused by profit margin variations. As of July 29, the Shiller P/E is 27, which represents about a 2.66% increase from its value as of July 1. Additionally, the current Shiller P/E is about 61.7% higher than the mean Shiller P/E.
Based on Shiller’s P/E valuations for different sectors, energy and financial services stocks present good investing opportunities since these sectors have a Shiller P/E less than 20. On the other hand, communication services and real estate sectors are likely sectors to avoid as the Shiller P/E is about 30 and over 56.
Insiders remain bearish as indices continue to rise
As the Dow Jones industrial average reaches a new high and the Standard & Poor’s 500 index continues to increase, insiders continue to sell more of their company stock. As of July 1, the insider buy/sell ratio decreased from 0.51 to 0.37. Furthermore, the CEO buy/sell ratio was cut in half, dropping from 0.58 to 0.30.
Decreasing corporate profit margins hint at upcoming recession
The after-tax corporate profit margin has decreased since 2014 when it reached a 10-year high of 10.2%. As of 2016, the corporate profit margin is 7.74%, about 74 basis points higher than the profit margin when the 2008 financial crisis occurred. This suggests that there is a small “margin of safety”: if the profit margin decreases about 0.8% in the short term, the market is likely to go into recession.
Conclusions
Based on the above market valuations, the stock market is severely overvalued and is likely to go into recession once a major “financial bubble” bursts. As the market valuations continue to increase, two model portfolios that outperformed the market in most years are the Broadest Owned portfolio and the Buffett-Munger portfolio. For stocks that present good “defensive” investments, view the Aggregated Portfolio of Gurus and the Buffett-Munger Screener.
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