The stock market is Modestly Undervalued, it is likely to return 11% a year in the next 8 years. GuruFocus has developed a stock market valuation tool which shows the daily market valuations. The market valuation is assigned as Over-Valued, Fair-Valued or Under-Valued. The market valuation is based on the ratio of the total US market cap relative to the US economy.
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.” The chart on the right shows what would happen if GDP is used instead of GNP.
Total Market Cap and US GDP
The Ratio of Total Market Cap to US GDP
The Predicted and the Actual Stock Market Returns
In the long run, stock market valuation reverses to its mean. A higher current valuation certainly results in lower long term returns in the future. On the other hand, a lower current valuation level results in a higher future long term return. The total market valuation is measured by the ratio of total market cap (TMC) over GNP, this is Warren Buffett's "best single measure". This ratio since 1970 is shown in the middle chart at the right. This ratio is updated daily. As of 04/11/2009 , this ratio is 61.6%.
We can see that during the past four decades the TMC/GNP ratio has varied wildly. The lowest point was about 35% in the previous deep recession of 1982, while the highest point was 148% during the tech bubble in 2000. The market went from extremely undervalued in 1982 to extremely overvalued in 2000.
Based on these historical valuations, we have divided the market valuation into five zones:
|Ratio = Total Market Cap / GDP||Valuatoin|
|Ratio < 50%||Significantly Undervalued|
|50% < Ratio < 75%||Modestly Undervalued|
|75% < Ratio < 90%||Fair Valued|
|90% < Ratio < 115%||Modestly Overvalued|
|Ratio > 115%||Significantly Overvalued|
|Where are we today (4/11/2009)?||Ratio = 61.8%, Modestly Undervalued|
As discussed previously, the returns of investing in an individual stock or in the entire stock market are determined by these three factors: 1. Business growth, 2. Dividends, and 3. the Change in the market valuation, that is:
Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
This equation is actually very close to what Dr. John Hussman uses to calculate market valuations. From this equation we can likely return of the stock market. In the calculation, the time period we used was 8 years, which is about a full economic cycle. The calculated results are shown in in the bottom chart at the right. The green line is the expected return if the market becomes undervalued (TMC/GNP=40%) in 8 years from current levels, the red line is if the market becomes overvalued (TMC/GNP=120%) in 8 years. The brown line is if the market becomes fair-valued (TMC/GNP=80%) in 8 years.
The thick bright line in the bottom right chart is the actual annualized return of the stock market in 8 years. We can see the calculations largely predicted the trend in the returns of the stock market. The swing of the market returns is related to the change of the interest rate.
It has been unforunate for investors who entered the market after the late 1990s. The market has been always overvalued, only until the recent decline since 2008. From Oct. 2008, for the first time in 15 years, the market is positioned for meaningful positive returns.
As of 04/11/2009 , the stock market is likely to return 11% a year in the next 8 years.
The market valuation is updated daily at The Page of the Stock Market Valuations