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US Market Now Traded Above 100% of GDP for the Third Time Since 1970

September 19, 2012 | About:

It is a great market, isn’t it? From the beginning of the year, the S&P 500 has gained 16.4%, fueled by central banks’ quantitative easing actions around the world. We thought that the stock market was overvalued already at the beginning of the year…

If the central banks’ goal is to elevate the stock prices, they have done it successfully. But if their goal is to stimulate the economy, we are not sure if they have achieved their goal. But one thing is for sure, a higher current valuation of any asset classes always increases the risks of investing in them. A higher gain in the past means a lower gain in the future.

Now for the third time since 1970 (that is when our data become available), the total market cap index is more than 100% of the GDP. The other two times were in the late 1990s to 2000 and 2006 to 2007. Both ended badly, unfortunately.

Please see the chart below, which is from our total market valuation page:

Some investors may have forgotten; others were probably too young to experience the pain. The late 1990s to 2000 stock market was after a decade of bull market and fueled by the unprecedented tech bubble. The total market index was pushed to about 150% of GDP. But the burst of the tech bubble brought the S&P 500 from around 1530 in March 2000 to 800 in October 2002, a loss of 48%. The tech-heavy NASDAQ lost almost 80%. Today, 12 years later, even after strong recoveries, it is still about 40% lower than its peak in 2000.

The 2006 to 2007 high valuation was a byproduct of the housing bubble. The total market index was above 110% of the GDP, which is much lower than its 2000 peak, but it ended even worse. The S&P 500 lost more than 56% from its peak in October 2007 to its trough in March 2009. The economic impact was much broader and it lasted much longer.

The quantitative easing programs started in 2009 definitely eased investors’ fear and pushed them back into stocks. What else could they do? In 2007 an investor could buy government bonds which yielded around 6%, or he could buy a CD with a 5% interest rate. But what can he do today? He was told that stock dividend yield is now higher than government bond yield, so stock is a better investment. Now the total market index is more than 100% of the GDP, again, the third time.

How will this one end?

At its current market valuation, though lower than it was in 2007, the implied return is actually lower than it was in 2007 because of the declined growth rate of the economy. An alternative approach, Shiller P/E, is predicting an even lower return. Please see the chart below:

The chance for the stock market to do well from this point on requires the market valuation to go even higher and stay high for long enough so that the economy can catch up. Will this happen? Well, nothing is impossible.

What should you do? The answer is it depends. If you are investing other people’s money and your goal is to beat the market average, you should invest in high-quality companies that are traded at reasonable prices, like the ones we have for our Buffett-Munger portfolio, which has gained 19% this year and beat the market index every year since inception. If you are investing your own money, you are more likely concerned about absolute returns. You don’t want to be in a situation when the market lost 40% and you “just” lost 35%. If that is the case, you may have to be patient, willing to sacrifice short-term gains and focus more on risks and long-term returns.

Either way, don’t expect too much for the stock market from this point on.

Rating: 4.1/5 (26 votes)


JUDS1234567 - 5 years ago    Report SPAM
Excellent point, be great if we could include Tobin Q. Anytime Tobin Q has been above 1 chances of a market decline are very very high.
Mocheng premium member - 5 years ago
S&P PE in 2000 peak was around 33, today it's about PE of 12. How could you say it's over priced?

I don't think there's a bubble at all in today's stock market, with interest rates so low and the fed printing a lot of cash. There are still a lot of money on the sidelines waiting for a good entry.

Gurufocus premium member - 5 years ago

The market certainly is not as overvalued as it was in 2000.

Regarding to P/E ratio, please read this page about Shiller P/E
Seanxtang - 5 years ago    Report SPAM

Why U.S. stock market cap reaches U.S. GDP is a bad omen? You have not established anything between the stock market valuation and GDP!

Here is my 'caculation': if the whole United States is just one giant company, and GDP is its annual revenue. Then this ginat company's market cap is just 1x it's annual sales. That is a pretty a very good valuation! You know that GE is trading at 1.62x sales. Thus the whole US stock market is 62% UNDERVALUED!

And GDP is more like earnings. So this giant company is trading at just 1x EPS. And you're already Chicken Little?
Brucechin - 5 years ago    Report SPAM
Shiller's P/E is not a good indicator for buying stocks. The problem with Shiller's P/E which argues the market is expensive now and to sell is that it has been issuing that sell signal for a long, long time. This is espoused from Birinyi.. the bigger issue is that Shiller's P/E has never really offered a BUY entry since it hasn't been meaningfully below it's mean in decades! Thus, there really isn't anything to sell now given it's been saying the market has been overvalued forever.. So, if you are looking for a short cut for a market valuation, Shiller's P/E is not a good one to use..

Haoafu - 5 years ago    Report SPAM

About a year ago, Joel Greenblatt said in an interview that stocks were seriously undervalued. Major indexes are not too far above the level then.

I see a lot of undervalued stocks anyway, and I think the expected inflation rate will add to the rate of return at least moderately.
Shaved_head_and_balls - 5 years ago    Report SPAM
Buffett is not good at macro calls. His intermittent gloomy predictions for bonds have been wrong for 30 years. I doubt that he uses the GNP-based valuation metric at all in his investment choices.

The ratio in question might not be an indicator of overvaluation. It might indicate that big companies in America are getting relatively bigger over time as a result of emerging markets boosting revenues. (China and Russia were not trading partners in the 1970s and part of the 1980s.)

I think the Shiller PE is a better apples-to-apples valuation metric, for those who love macro calls.

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