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Where Are We with Market Valuations?



03/10/2010:
The Stock Market is Fairly valued. Based on historical valuations, it is likely to return 5.7% a year from this level of valuation. This page is updated daily with the market.

Total Market Cap and US GDP

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The Ratio of Total Market Cap to US GDP

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The Predicted and the Actual Stock Market Returns

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What returns can we expect from the stock market?

As of today, the Total Market Index is at $ 11874.7 billion, which is about 82.1% of the last reported GDP. The US stock market is positioned for an average annualized return of 5.7%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 2.03%.

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.”

Over the long term, the returns from stock market are determined by these factors:

1. Interest rate

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett

2. Long Term Growth of Corporate Profitability

Over long term, corporate profitability reverses to its long term trend, which is around 6%. During recessions, corporate profit margin shrinks, and during economic growth periods, corporate profit margin expands. However, Long term growth of corporate profitability is close to long term economic growth. The size of the US economy is measured by Gross National Product (GNP). Although GNP is different from GDP (gross domestic product), but the two numbers have always been within 1% in difference. Therefore, GDP is used here for calculation purposes. The US GDP since 1970 is shown in the top chart at the right.

3. Market Valuations

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 03/10/2010, this ratio is 82.1%.

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 (03/10/2010)? Ratio = 82.1%, Fairly valued

The Sources of Investment Returns



The returns of investing in an individual stock or in the entire stock market are determined by these three factors:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

What Returns Is the Market Likely to Deliver From This Level?

Putting all the three factors together, the return of an investment can be estimated by the following formula:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

The first two items of the equation are straightforward. The third item can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated from this:

(Re/Rb)(1/T)-1

The investment return is thus equal to:

Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1

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 03/10/2010, the stock market is likely to return 5.7% a year in the next 8 years.

Warren Buffett’s Market Calls


Based on these factors, Warren Buffett made a few market calls in the past. In Nov. 1999, when Dow was at 11,000, a few months before the burst of dotcom bubble, stock market had gained 13% a year from 1981-1998. Warren Buffett said in a speech to friends and business leaders, “I'd like to argue that we can't come even remotely close to that 12.9... If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

Two years after the Nov. 1999 article, when Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

Nine years have passed since the publication of the article of November 22, 1999, it has been a wide and painful ride for most investors; Dow went as high as 14,000 in October 2007 and retreated painfully back to 8,000 today. Again, Warren Buffett wrote in Oct. 2008: Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”



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User Notes, Comments, and Questions
Gurufocus,

The total market value divisor is 1059.32 (in millions) and that puts the
total market at 12.293 (in millions) and the full-cap total market at
13.453 (in millions). The percentages are then 86% and 94%. Why don't
you use the US Total Market full cap? The data can be found at
[www.djindexes.com].

Thanks for posting and updating this information.
Buffetteer17, thanks for your answer. I look forward to seeing your investment returns. By the way, where can I see your returns? Is there a link/website? Best regards

Latc, what does my track record have to do with this argument? Nothing. That question is implicitly an ad hominem attack on me. You accuse me of attacking you but I have not, at least not intentionally. I only disagreed with your logic and called it nonsense. That's strong language, but I had thought you could tell from the context that the sentence was intended to be humorous rather than vindictive. I guess I just do not have a good sense of humor. That statement is intended as an attack of your argument, not against you. I am sorry if you took it as a personal attack.

Next you make an appeal to authority, by referring to Buffett. I am unsure of just what relationship you are talking about. Is it the fact that stocks are sometimes mis-priced? Buffett has consistently maintained that the intrinsic value of a company is the discounted present value of future "owner earnings," which, while not exactly the same as net cash flows, is pretty close. He apparently believes this strongly, as he put this statement in his Owner's Manual [http://www.berkshirehathaway.com/ownman.pdf]: "Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life."

I will shortly be posting my usual "Quarterly Report on The Porfolio Q4 2009," which will answer your question about my investing returns. You can have the last word in this argument. I am done.
Buffetteer17, what is your track record on investments, let’s say in the last 10 years? Even Warren Buffett has talked about the relationship that you are dismissing, so instead of attacking show me your performance track record based on your theoretical assumptions.
I'm sorry, but you cannot sell me nonsense by claiming to be fresh out of sense. The flaw in your argument is that future net cash flows are hard to predict accurately WHETHER OR NOT interest rates are high or low. The definition of intrinsic value is mathematically precise, just not calculable. All we can do is make our best estimates to actually calculate the present value. Unless you think there will be an inverse correlation between the level of interest rates and the level of corporate profits, your argument is not valid. Historically there is no such inverse correlation. In fact, I have read (forget the source) that profits and interest rates tend to be directly correlated as long as interest rates are not at extreme highs or lows.
Buffetteer17, I know the theory but theory normally does not work, I can not precisely predict net cash flows many years out, can you? Therefore, I just go one year out, in this regard, the current 10 year-Treasury yield is only 3.8% while the S&P 500 earning yield (using the expected earnings for 2010) is around 6.9%, so clearly stocks are undervalued vis a vis bonds right now. I do not have the TM expected earnings for 2010 but I am sure the result will show the same conclusion.
If you believe that current low interest rates will persist for a decade or more, your reasoning is correct. Reminder: the discounted value of net cash flows is the correct theoretical measure of the value of a stock. However, remember that this formula refers to net cash flows far in the future as well as near term. If you believe, as I do, that interest rates will rise significantly during the next decade, you must use a much higher discount rate for all but the next 2-3 years of net cash flows. This adjustment causes the value of stocks to be much less.
This stock market valuation TMC vis a vis GDP gives a partial view on the over/under/fair valuation of the stock market. The level of interest rates needs to be incorporated into the equation to provide a more complete view. So, the current low level of interest rates justifies a higher TMC/GDP ratio, hence I would argue that stocks are currently undervalued.
Alahendrix,

We use Wilshire 5000 for the measurement of total market cap, which is different from what Buffett and Van Den Berg use. They use the total of all stocks traded. We do not have the daily data for that. Their numbers are higher than Wilshire 5000.

But relatively speaking, the overall picture is the same.

GuruFocus.
You guys are calculating TMC/GDP differently than most. For i.e, Arnold Van DeBerg, whom you site, acutally has today's TMC/GDP well over 100%. He pegged it at 108% back in Oct!

So, while using the Wishire 5000 is interesting for your Market Cap input, it is somehow very off from Buffett's data points and Van DeBerg's as well. If you're going to use this metric, you should at least make sure that it is accurate. And clearly it is not!
Can anybody clarify if the TMC number has been adjusted to exclude foreign ADRs traded in the US? If this is not the case, then stocks might be undervalued.
The first graph - "Total Market Cap and US GDP" would serve better if it were in log scale. The graph gives the false impression that valuations were at record low levels in early 2009. The "The Ratio of Total Market Cap to US GDP" graph gives a much more realistic representation of the relative valuations over time.
Does anybody have a website with a similar graph for China's equity markets? In addition, anyone have a graph for the U.S. going back further than 1970? It could be interesting to check out what the valuations were like during the Ben Graham days.
The 12/10/2001 Fortune article covering W.B. on the stock market clearly states that TMC/GNP peaked at 190% in 3/2000, not the 148% stated in the GF article. The actual TMC/GNP valuation on 10/9/09 approximates 97%. WB states "... if the percentage relationship falls to 70%-80%, buying stocks is likely to work very well..."
That looks really cool. This is simple enough to understand. No wonder Buffett is so beloved.

This site just published an article to take this a step further: they backtested this metric as a timing indicator. Interesting is if you only buy at the significantly undervalued and sell at the significantly overvalued, you would have avoided the last two bubbles and made 9.7% (?) per year since 1980. See this link: [www.validfi.com].

Sorry, how do you put an embedded link on gurufocus.com?

JC.
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