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What Market Returns Can You Expect from Its New All-Time High?

March 06, 2013 | About:

The market is continuing to make new highs and it feels like everyone is making money in this market but you. While we never have ideas on where the market will go in short term, but in long run, we believe that future market return is a function of economic growth and current market valuations. Today’s high returns always eat into future market gains. Maybe everyone else is making money and you didn’t, but you can feel better because at times like this, some great investors like Warren Buffett and Don Yacktman underperform, too. Buffett wrote in his latest shareholder letter: “We do better in headwinds.” Economist John Hussman has been widely criticized for his underperformances in the last few years.

GuruFocus hosts three pages about market valuations. The first is the market valuation based on the ratio of total market cap over GDP; the second is the measurement of the U.S. market valuation based on the Shiller P/E. These pages are for the U.S. market. We have also created a new page for international markets. You can check it out here. All pages are updated at least daily. Monthly data is displayed for the international market.

Market Valuation Based on the Ratio of Total Market Cap over GDP

As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.” You can learn the details on why this is important and how we do the calculation in our Market Valuation page. This page is updated daily.

As of today, the Total Market Index as measured by the Wilshire 5000 index is at $16,258.5 billion and it is now 103% of the U.S. GDP. The stock market will return about 3% a year in the coming years, including dividends. As a comparison, in January 2012, the ratio of total market cap over GDP was 87.4%; it was likely to return 5.7% a year from that level of valuation. The 20% gain since the beginning of 2012 has reduced the future gains by about 2.7% a year.

The historical prediction from this model and the actual market performance is show here:

Historically since 1970, only two periods had comparably low market returns, which are the late 1990s and 2007. Both were followed by steep market declines.

Shiller P/E Ratio

Prof. Robert Shiller of Yale University invented the Schiller P/E to measure the market's valuation. The Schiller P/E eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles and tries to give a fair market valuation. You can learn the details of why we use Shiller P/E and how it is calculated in GuruFocus Shiller P/E page.

At 23, the Shiller P/E is 39.4% higher than the historical mean of 16.5. The implied future annual return is 2.2%, including dividends. As a comparison, the regular trailing 12-month P/E is 18, slightly higher than the historical mean of 16. That is also why the media pundits are saying that the market is cheap.

Twelve months ago, the Shiller P/E was 26.4, and the regular trailing 12-month P/E was around 14. The market did look cheap with the trailing 12-month P/E.

The Shiller P/E chart is shown below:

John Hussman’s Price to Peak Earnings

John Hussman uses the peak P/E ratio to smooth out the distortion of the corporate profits caused by the fluctuations of the profit margins. The current market return projected by his model is around 3.8% a year.

This is the historical prediction and the actual market performance from his model:


He wrote: “Valuations are presently rich on every well-tested metric – even forward operating earnings, provided they are not used naïvely (see Valuing the S&P 500 Using Forward Operating Earnings). Secular bull markets don’t begin at valuations associated with 3.8% annual returns for a decade – secular bears do. The near-zero returns of the S&P 500 since 2000 were the predictable outcome of extreme valuations. Valuations have moved from stratospheric in 2000, to about average in 2009, to rich-but-not-stratospheric today. Still, valuations are easily rich enough to produce disappointing returns, with significant volatility, over the coming decade.”

GMO Seven-Year Projection:[/b]

Jeremy Grantham’s firm GMO publishes a monthly seven-year market forecast. As of Jan. 31, GMO’s seven-year forecast is below:

[b]Asset Class Annual Real Return US Large Cap -0.5% US Small Cap -1.7% US High Quality 4.2% International Large Cap 3.1% International Small Cap 3.3% Emerging Market 5.4% US Bonds -0.7% International Bonds -1.40% emerging Debt 1.8% Index Linked Bonds -2.0% Cash 0.1%
GMO expected U.S. large cap real return (inflation adjusted) of -0.5%. This number agrees with what we find out with market/GDP ratio and Shiller P/E ratio. The U.S. high quality will have a higher return. The return is expected to be 4.2% a year.


If average investors are excited about the current market, company insiders, including CEOs, CFOs and directors are not excited at all. The insider buy/sell ratio is close to its lowest level. It sits at 0.22 now.

Historically, if this ratio is above one, it means that more insiders are buying than selling. This happened twice since 2004. One is during the period of bear market from October 2008 to March 2009. The other is after the mini crash of September 2011. Both proved to be great buying opportunities.

This is the historical ratio of insider buys over insider sells:

Distressed Areas

Although the market is hot, it is not universally so. Many industries are traded at three-year lows. This might be an area to find bargains for real value investors. You can see the industries that are out of favor from the page of Stocks at 3-Year Lows and 5-Year Lows.

In the list of three-year lows, we found that industries like Metals & Mining, Oil & Gas - E&P and Communication Services are traded at multi-year lows. Many of those stocks have lost more than 80% of their values. For-profit education is another industry that is in distress. As pointed out by Barel Karsan, many of the stocks are traded at below net cash. Are you brave enough to buy those net-nets?

What to Do Now?

Because the market will return 2% to 3% a year for the next couple of years, most of the future returns will be from dividends, and the market index will likely to be flat even after many years.

If you want to stay in the market, historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high quality business and strong balance sheets will provide better returns in this environment.

If you are looking for these kind of companies, please check out GuruFocus’ Buffett-Munger Screener. "Buffett-Munger Screener" is the screener we created to find companies with high quality business at undervalued or fair-valued prices:

Companies that have high Predictability Rank, i.e. companies that can consistently grow revenue and earningsCompanies that have competitive advantages, i.e. can maintain or even expand profit margins while growing their businessCompanies that incur little debt while growing businessCompanies that are fair valued or under-valued. We use PEPG as indicator. PEPG is the P/E ratio divided by the average growth rate of EBITDA over the past five years.If you are not a Premium Member, as always, we invite you for a 7-day Free Trial.

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