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Vera Yuan
Vera Yuan
Articles (1063) 

Market Valuations and Expected Returns – Sept. 4, 2013

September 05, 2013 | About:

In the first eight months of 2013, the stock market benchmark S&P 500 gained 2.44% in January, 0.10% in February, 3.36% in March, 2.27% in April, 3.04% in May, -0.97% in June, 5.69% in July and -3.93% in August. Since 2013, the year-to-date return for the S&P 500 is 12.13%. The market reached its historical high on Aug. 2, 2013, and then started declining. So far this is the biggest loss for one month in 2013.

Investors remained cautious over a possible attack on Syria. The prospect of the Federal Reserve scaling back its $85 billion bond purchase program as soon as September hit the market. However, the economic data is stronger. The second-quarter GDP grew at 2.5% annualized pace, which is higher than what economist were expecting. The decline in jobless claims can also be seen as a good economic sign.

As investors are happier with the higher balances in their account, they should never forget the word “RISK”, which is directly linked to the valuations of the asset they own. A higher current valuation always implies a lower future returns.

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 US 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 international market.

Why is this important?

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.”

Knowing the overall market valuation and the expected market returns will give investors a clearer head on where we stand for future market returns. When the overall market is expensive and positioned for poor returns, the overall market risk is high. It is important for investors to be aware of this and take consideration of this in their asset allocation and investing strategies.

Please keep in mind that the long-term valuations published here do not predict short-term market movement. But they have done a good job predicting the long-term market returns and risks.

Wise man Howard Marks also pointed out that investors should always know where we are with the market. Predicting the direction of the market is hard. But investors can always make educated decisions based on current conditions.

Howard Marks says, “Most assets are neither dangerously elevated (with the possible exception of long-term Treasury bonds and high grades) nor compellingly cheap. It’s easier to know what to do at the extremes than it is in the middle ground, where I believe we are today,” according to his latest memo.

Why did we develop these pages?

We developed these pages because of the lessons we learned over years of value investing. From the market crashes in 2001 to 2002 and 2008 to 2009, we learned that value investors should also keep an eye on overall market valuation. Many times value investors tend to find cheaper stocks in any market. But a lot of times the stocks they found are just cheaper, instead of cheap. Keeping an eye on the overall market valuation will help us to focus on absolute value instead of relative value.

The indicators we develop focus on the long term. They will provide a more objective view on the market.

Ratio of Total Market Cap over GDP - Market Valuation and Implied Returns

The information about the market valuation and the implied return based on the ratio of the total market cap over GDP is updated daily. The total market cap as measured by Wilshire 5000 index is now 108.4% of the US GDP. The stock market is likely to return about 2.6% a year in the coming years. As a comparison, at the beginning of 2013, the ratio of total market cap over GDP was 97.5%. It was likely to return 4% a year from that level of valuation. The 10.9% gain since the beginning of 2013 has reduced the future gains by about 1.4% a year.

For details, please go to the daily updated page. In general, 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 it 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 the long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividends are an important portion of the investment return. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still 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, its stock price often 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 businesses, 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.

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 (%)

From the contributions we can get the predicted return of the market.

The Predicted and the Actual Stock Market Returns

This model has done a decent job in predicting the future market returns. You can see the predicted return and the actual return in the chart below.


The prediction from this approach is never an exact number. The return can be as high as 10% a year or as low as -6% a year, depending where the future market valuation will be. In general, investors need to be cautious when the expected return is low.

Shiller P/E - Market Valuation and Implied Returns

The GuruFocus Shiller P/E page indicates that the Shiller P/E is 23.1. This is 40% higher than the historical mean of 16.5. Implied future annual return is 2.2%. As a comparison, the regular trailing 12-month P/E is 19, higher than the historical mean of 15.8. That is also why the media pundits are saying that the market is cheap.

Twelve months ago, the Shiller P/E was 21.8, and regular trailing 12-month P/E was around 15. The market did look cheap with the trailing 12-month P/E.

The Shiller P/E chart is shown below:

Over the last decade, the Shiller P/E indicated that the best time to buy stocks was March 2009. However, the regular P/E was at its highest level ever. The Shiller P/E, similar to the ratio of the total market cap over GDP, has proven to be a better indication of market valuations.

Overall, the current market valuation is more expensive than the the majority of the last 130 years. It is cheaper than most of the time over the last 15 years.

To understand more, please go to GuruFocus' Shiller P/E page.

John Hussman’s Peak P/E:

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 2.8% a year.

In his commentary on Aug. 12, 2013, Extreme Brevity of the Financial Memory, he estimates that the prospective 10-year S&P 500 nominal total return is about 2.8% annually. He believes that investors could be looking at a higher S&P 500 and even worse prospective long-term returns a year from now. “As unpleasant as these numbers may be, S&P 500 revenues are presently at 1105, and Shiller earnings are presently about 69. On the basis of historical norms, deviations from which are highly related to subsequent market returns, a level of about 960 on the S&P 500 – nearly 45% below present levels – would be associated with historically average total returns. By contrast, the present level of about 1700 is associated with expected 10-year total returns for the S&P 500 that are among the lowest in history. Given a 2.6% 10-year Treasury bond yield, investors may be comfortable accepting weak prospective long-term returns for the S&P 500 – we estimate about 2.8% annually over the coming decade. From our perspective, the expected “equity risk premium” here is non-existent, and the intervening downside risks are extraordinary.”


This agrees with the returns projected by the ratio of total market cap over GDP and Shiller P/E.

In all of the three approaches discussed above, the fluctuations of profit margin are eliminated by using GDP, the average of trailing 10-year inflation-adjusted earnings and peak-P/E, revenue or book value, etc. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only 2.2% to 2.8% a year in future years.

Jeremy Grantham’s 7-Year Projection:

Jeremy Grantham’s firm GMO publishes a monthly 7-year market forecast. In Inker and James Montier’s quarterly letter What the *&%! Just Happened? and The Purgatory of Low Returns, it noted that today’s opportunity set is characterized by almost everything being expensive. James Montier believes this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world. James Montier advises that investors should “be patient” at this point.

As of July 31, 2013, GMO’s 7-year forecast is below:


GMO expected U.S. large cap real return to be -2.1%. This number does not agree with what we find out with market/GDP ratio and Shiller P/E ratio. The U.S. high quality’s return is expected to be 3.1% a year.

Insider Trends

As indicated by the three different approaches discussed above, the best buying opportunities over the last five years appeared when the projected returns were at their highest level from October 2008 to April 2009, when investors could expect 10% a year from the U.S. market.

If average investors missed this opportunity, corporate insiders such as CEOs, CFOs and directors did not. As a whole they purchased their own company shares at more than double the normal rate from October 2008 to April 2009. Many of these purchases resulted in multi-bagger gains. This confirmed again the conclusions of earlier studies: The aggregated activities of insiders can serve as a good indicator for locating the market bottoms. Insiders as a whole are smart investors of their own companies. They tend to sell more when the market is high, and buy more when the market is low.

This is the current insider trend for S&P 500 companies:


The latest trends of insider buying are updated daily at GuruFocus' Insider Trend page. Data is updated hourly on this page. The insider trends of different sectors are also displayed in this page. The latest insider buying peak is at this page: September 2011, when the market was at recent lows.

Conclusion: The stock market is not cheap as measured by long term valuation ratios. It is positioned for about 2.2% to 2.8% of annual returns for the next decade. By watching the overall market valuations and the insider buying trends investors will have a better understanding of the risk and the opportunities. The best time to buy is when the market valuation is low, and insiders are enthusiastic about their own companies' stocks.

Investment Strategies at Different Market Levels

The Shiller P/E and the ratio of total market cap over GDP can serve as good guidance for investors in deciding their investment strategies at different market valuations. Historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high quality business and a strong balance sheet will provide better returns in this environment. When the market is cheap, beaten-down companies with strong balance sheets can provide outsized returns.

To summarize:

1. When the market is fair valued or overvalued, buy high-quality companies such as those in the Buffett-Munger Screener.

2. When the market is undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener. Buy a basket of them and be diversified.

3. If the market is way over valued, stay in cash. You may consider hedging or short.

Rating: 4.0/5 (7 votes)


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