As of Nov. 4, the U.S. total market cap / gross domestic product ratio is 115.9%. While the stock market is still significantly overvalued, the market valuation improved by about 6% compared to the Oct. 4 valuation.
A summary of the market valuation based on two metrics
Warren Buffett (Trades, Portfolio) and Robert Shiller present two separate market valuation metrics based on the market price-sales ratio and the price-to-E10 ratio, respectively. The former, according to Buffett, is “probably the best single measure” for the market valuation, as P/S valuations generally revert to the mean. The total market index as of Nov. 4 is $21.61 trillion, about 115.9% higher than GDP. Buffett’s indicator suggests an annual return of 0.7% including dividends.
While the market valuations followed the pessimistic case in the late 1970s, the valuations generally followed the expected case that assumes a TMV / GDP ratio of 80% since 1994. The expected annual market return ranges from -7.2% to 5.7% based on current market valuations.
Shiller, a professor at Yale, presents an alternative valuation measure based on the inflation-adjusted earnings for the past 10 years, or E10. As of November, the U.S. market has a Shiller P/E of 26.4, about 58% than the historical median. Unlike Buffett’s valuation, which implies a positive annual return, this valuation implies a future annual return of -0.3%. Despite this, the Shiller P/E decreased 0.17% during October.
Insiders becoming bullish about stock market
Even though the insider buy / sell ratio reached near a five-year low Aug. 1, the ratio increased over 10% during the third quarter. As of Nov. 4, the insider buy / sell ratio is 0.5 while the CEO buy / sell ratio is 0.56. While the former remained the same throughout October, the latter increased 10%. Chief financial officers also significantly increased their buy / sell ratio: during October, the chief financial officer buy / sell ratio increased 14%. Based on these trends, company management is generally becoming bullish about the stock market.
SP 500 earnings slightly improve after sharp 2015 decline
After reaching a five-year high Sept. 2, 2014, S&P 500 earnings steadily declined throughout 2015, likely due to tumbling crude oil prices. However, the earnings gradually increased during the past nine months as crude oil prices climb from a 10-year low. The increase in S&P 500 earnings suggest that the U.S. stock market shows good improvement from prior months.
Conclusions and see also
Although stock market valuations improved since October, the U.S. stock market remains significantly overvalued. This suggests that there is still high recession risk. As discussed in the research article, many investors suffered high losses of capital during the 2008 financial crisis. Several investing strategies that once worked resulted in net losses, permanently reducing invested capital. However, one strategy generally outperformed the stock market: the Buffett-Munger strategy.
The co-managers of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) developed a four-criteria approach to investing: understandable business, high predictability, sustainable competitive advantage and little debt.
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Disclosure: No position in Berkshire Hathaway.
