With a total market cap / gross domestic product ratio of 122.3%, the U.S. stock market is still significantly overvalued as of Sept. 1. Based on this ratio, the stock market is expected to return 0% per year for the next eight years, including dividends.
Market valuations still follow expected trends
As discussed in the previous article, the TMC / GDP ratio best measures where valuations stand at any given moment. Warren Buffett (Trades, Portfolio)’s “best single measure” assumes that the stock market valuations revert to the mean, resulting in lower expected returns as the TMC / GDP ratio increases. Although the ratio has gone down slightly since July 29, the Buffett indicator is still significantly high. As implied by the charts below, the Wilshire total market index steadily increased during the past five years. As of Sept. 1, the total market index is valued at $22.556 trillion, about 22.3% higher than the GDP.
Despite the high valuations, the stock market returns still follow expected trends. Since the third quarter of 2014, the actual returns closely follow the expected trendline that assumes a TMC / GDP ratio of 80%. Highlighted in blue, the expected trendline suggests an annual return of 0% for the next eight years.
Since July 29, the expected annual returns for both the optimistic case and the pessimistic case had a negligible net change. In the extremely optimistic case, which assumes a TMC / GDP ratio of 120%, the expected annual return is 5.0%. Likewise, the extremely pessimistic case implies an expected annual return of -7.8%.
Shiller P/E offers an alternate market valuation metric
Robert Shiller, economics professor at Yale University, formulated his own definition of the price-earnings (P/E) ratio to measure market valuation. Since it eliminates ratio fluctuations due to profit margin variations, the Shiller P/E ratio more accurately values the market than the regular P/E ratio. The Shiller P/E increased since 2009, climbing above the historical mean of 16.7 by September 2009. As of Sept. 1, the market Shiller P/E ratio is 27.1, which implies an expected future return of -0.7%.
Several sectors have Shiller P/E ratios significantly lower than the market Shiller P/E. Energy and financial services companies still have the lowest sector Shiller P/E ratios, compared to July 29 valuations. On the other hand, the real estate sector has the highest Shiller P/E ratio of 56.4, about twice as high as the market Shiller P/E. The sector Shiller P/E ratios show that the market is rarely balanced, allowing investors to invest in relatively cheap sectors.
High market valuations lead to more insider sells
Since June 1, the insider buy / sell ratio steadily declined month over month, implying more insider sells than buys. As of Sept. 1, the Standard & Poor’s 500 exchange-traded fund traded at $217.35, which is near a 10-year high. While it decreased slightly in late 2015, the ETF’s price generally increased after the 2008 financial crisis.
During the month of July, the insider buy / sell ratio decreased 0.05% to its Aug. 1 value of 0.32. Despite this, both the CEO buy / sell ratio and the chief financial officer buy / sell ratio increased: as of Aug. 1, the CEO buy / sell ratio was 0.42, and the CFO buy / sell ratio was 0.26.
After-tax corporate profit margins slightly improve but still relatively low
Current after-tax corporate profit margins are near 8%, which is close to the 10-year median. Although the margin slightly increased from late 2015 to early 2016, the corporate profit margin generally decreased during the past five years. This suggests potential signs of a coming recession.
As shown in the chart above, the last U.S. recession occurred when the after-tax corporate profit margin dipped below 7%. While the corporate profit margins peaked near all-time highs in 2013, the margins sharply declined in the last three years.
Conclusions and see also
As the stock market is severely overvalued, Buffett and Charlie Munger (Trades, Portfolio), co-managers of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), suggest that investors stay defensive and look for undervalued predictable companies. The Buffett-Munger strategy, as summarized on the model portfolios page, generated positive annual returns in seven of the past eight years. You can view companies that meet Buffett’s criteria using the Buffett-Munger Screener.
Additionally, you can use the Backtesting feature nested inside the All-in-One Guru Screener to find top-performing value strategies. A previous article discussed the Backtesting feature and identified which of the predefined GuruFocus value screeners had high portfolio returns in the past 10 years. The Piotroski Score Screener generated strong short- and long-term returns, and outperformed the S&P 500 ETF each year since 2006 as summarized in the following table.
| Year | S&P 500 ETF | Buffett-Munger | Most Broadly Held | Piotroski Portfolio |
| 2006 | 13.74% | N/A | 15.18% | 33.94% |
| 2007 | 3.24% | N/A | -5.47% | 3.27% |
| 2008 | -38.28% | N/A | -29.98% | -37.97% |
| 2009 | 23.49% | 28.65% | 30.70% | 93.46% |
| 2010 | 12.84% | 19.54% | 14.63% | 31.81% |
| 2011 | -0.20% | 6.01% | 0.54% | 3.17% |
| 2012 | 13.47% | 12.05% | 16.99% | 34.23% |
| 2013 | 29.69% | 30.37% | 30.85% | 85.44% |
| 2014 | 11.29% | 2.94% | 12.30% | 21.56% |
| 2015 | -0.81% | -10.89% | 6.07% | 11.39% |
| 2016 YTD | 6.52% | 14.84% | 0.38% | -0.07% |
| All-time | 74.41% | 150.88% | 110.20% | 660.19% |
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