>
  1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Robert Abbott
Robert Abbott
Articles (882)  | Author's Website |

30,000 Dow? Be Nervous

The dangers of an overheated market, and two resources for dealing with it

On Tuesday, Nov. 24, the Dow Jones Industrial Average surpassed the 30,000 mark for the first time.

If anything says Mr. Market has put the blahs of the spring meltdown in his rearview mirror, this might be it.

Or does it?

It all depends on the context. And that context comes from broader economic indexes such as gross domestic product and gross national product. That is roughly how Warren Buffett (Trades, Portfolio) views overall stock valuations: How does the gross market capitalization compare with GDP or GNP?

The Buffett Indicator

It's now easy to check on the relationship between the economy and stock valuations thanks to a GuruFocus service, the Buffett Indicator. It charts how well one tracks the other:

Buffett Indicator

Traditionally, the capitalization and GDP line have been roughly parallel, at least since 1971, where this chart originates. Why 1971? That's the year the Wilshire 5000 Full Cap Price Index, a proxy for market capitalization, was started.

As the chart shows us, the Wilshire 5000 took off in the wake of the 2008 financial crisis and has not turned back since. Fueled mainly by low interest rates, corporations have found ample capital to grow, fund dividends and repurchase shares. The resulting growth of revenue and earnings have heated up stock prices.

But there is a price to be paid for hot stock prices. As the GuruFocus page for the Buffett Indicator explains, returns are expected to be lower when capitalizations are higher.

Over time, these valuations will revert to their means. Or to put it more simply, what goes up must come down, and vice versa. Today's hot valuations will revert to lower valuations in the future.

On Nov. 24, the valuation ratio was 179.10%. When it reverts to 100%, we can expect a lot of lower share prices. As the page notes, "The US stock market is positioned for an average annualized return of -2.1%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 1.57%."

That return of -2.1% is based on this formula: "Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)."

Tesla

Tesla Inc. (NASDAQ:TSLA) may symbolize overheated valuations, as its market cap closed at $524.95 billion, or more than half a trillion dollars. And look at its price-earnings ratio: On Nov. 24, it was 1,112.04. That is price divided by earnings. How many hundreds of years would you need to own the stock to profit from it? But, of course, that's not the point. This is a "greater fool" stock, with investors buying in hopes of later selling to someone else at an even higher price.

Perhaps I'm being too cynical. I see 14 gurus currently hold positions in Tesla. Ron Baron (Trades, Portfolio) of Baron Funds has the biggest, followed by PRIMECAP Management (Trades, Portfolio) and Philippe Laffont (Trades, Portfolio) of Coatue Management. All three have been richly rewarded for their ownership.

Laffont, for example, doubled his stake in the third quarter. That's not surprising when the current share price is 57.2% higher than his average acquisition cost. Baron and PRIMECAP are up by similar amounts. Each of these gurus owns millions of shares, between 3.1 million and 7.3 million, so the dollar rewards have been outstanding.

Shiller PE

In addition to the Buffett Indicator, there is also the Shiller PE, created by Professor Robert Shiller of Yale University. His goal was to develop a price-earnings ratio that took into account the cyclicality of stocks and industries. Also called the CAPE ratio (cyclically-adjusted price-earnings), it provides investors with an "adjusted" view of valuations.

Here are the GuruFocus results for the Shiller PE after the close on Nov. 24:

Shiller PE

It, too, signals that American markets are expensive.

What to do?

One way to avoid buying into an overvalued market is to invest in other countries. On its Global Market Valuations page, GuruFocus provides comparative returns by applying the Buffett Indicator model to other countries. Some have much lower valuations, as this chart shows:

Global Valuations

The chart implies that market valuations are lowest in Singapore, Spain and Hong Kong (I would add that new Chinese restrictions on the people and institutions of Hong Kong may make that a very uncertain place to invest).

For those who like to work in the English language, the United Kingdom, Australia and Canada all offer valuations low enough to generate positive returns.

GuruFocus also recommends its Aggregated Portfolio of Gurus when markets are overvalued. It explains, "GuruFocus' most broadly held strategy invests in the top 25 companies based on number of guru owners while the most weighted strategy invests in the top 25 companies based on combined weightings."

These are the top three stocks owned by one or more gurus:

GuruFocus Aggregated Portfolio

Conclusion

While a rising market provides profits from our stocks and portfolios, we must remember the potential consequences when market prices get too far ahead of the broader economy. We should be nervous as the market outpaces GDP in the U.S., and plan accordingly.

Both the Buffett Indicator and the Shiller PE ratio give us some broad context about valuations, about where the market has been and may go again (often sooner than we expect or want).

Finally, there are tools available that can help us deal with overvalued markets. They may not make a difference in the short term, but in the long term, we can always count on quality stocks bought when undervalued.

Disclosure: I do not own shares in any of the companies named in this article.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


Rating: 0.0/5 (0 votes)

Comments

Please leave your comment:



Performances of the stocks mentioned by Robert Abbott


User Generated Screeners


pjmason14Momentum
pascal.van.garsseHigh FCF-M2
kosalmmuse6
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
kosalmmuseNice
kosalmmusehan
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)