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Vera Yuan
Vera Yuan
Articles (1063) 

Market Valuations and Expected Returns – Nov. 8, 2013

November 08, 2013 | About:

In the first 10 months of 2013, the year-to-date return for the stock market benchmark S&P 500 is 20.46%. It gained 3.93% in October, the second biggest monthly gain since 2013, following 5.69% in July. At the end of October, it hit a new record high at 1771.95.

From Oct. 1 through Oct. 16, 2013, the U.S. federal government entered a shutdown. Yet the Institute of Supply Management (ISM) manufacturing index rose to 56.4, a two-and-a-half-year high in October, suggesting that U.S. industry wasn’t unduly affected by the government shutdown. The U.S. company earnings season is largely complete. Earnings are better than analysts’ estimates. However, earnings are mainly supported by cost cutting and margin expansion instead of revenue growth. Therefore, the earnings expansion trend may not be sustainable.

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 assets they own. A higher current valuation always implies 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 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.

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. China’s equities are “tremendous bargains” while U.S. stocks are “fairly to fully valued," he said in Shanghai on Nov. 4, 2013.

Why did we develop these pages?

We developed these pages because of the lessons we learned over the 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 113% of the US GDP. The stock market is likely to return about 2.1% 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%, and it was likely to return 4% a year from that level of valuation. The 20.46% gain since the beginning of 2013 has reduced the future gains by about 1.9% 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 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 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 24.2. This is 46.7% higher than the historical mean of 16.5. Implied future annual return is 1.6%. 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, Shiller P/E was 21.8, and regular trailing-12 month P/E was around 15. The market did look cheap with 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 most part 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. He currently estimates 10-year S&P 500 nominal total return of just 2.5% annually.

In his commentary on Nov. 4, 2013, "Leash the Dogma," he said he believed there is a largely unrecognized bubble in stock price. “I should also note that virtually every overvalued, overbought, overbullish syndrome we define is on red alert,” he said. The Shiller P/E is high now: “Prior to the late-1990’s bubble, the only time the Shiller P/E was higher was during three weeks in 1929 that accompanied the extreme peak of the market before stocks crashed. Meanwhile, the price/revenue ratio of the S&P 500 is presently 1.6 – a level that is doubles its pre-bubble norm, and even further above levels historically associated with bear market lows.”


According to John Hussman, another measure using “smooth” fundamentals is the ratio of stock market capitalization to nominal GDP, based on Federal Reserve Z.1 Flow of Funds data. “Again, the present multiple is about double the historical pre-bubble norm,”he wrote.


“Among the many largely equivalent ways to define an overvalued, overbought, overbullish syndrome, the blue bars on the following chart present one of the many we observe at present: Shiller P/E anywhere above 18 (overvalued), S&P 500 at a five-year high and at least 8% over its 40-week smoothing (overbought), with bullish sentiment greater than 50% and bearish sentiment less than 20% based on Investors Intelligence figures (overbullish). Notice that we did not observe this particular variant in 2000 because bearish sentiment never fell below 20% in that year. Also, while sentiment data was not available in 1929, we can impute sentiment reasonably on the basis of past price movements. Using imputed sentiment, we can also include 1929 in the set of instances here.”


“Notice that we’ve observed three instances this year – in May, in August, and today. Given the lack of follow-through from recent syndromes, we have to at least allow for the possibility of a further blowoff, as the seduction of quantitative easing has encouraged investors to ignore these conditions.”

In all 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 1.6%-2.5% annually in the future years.

Jeremy Grantham’s 7-Year Projection:

Jeremy Grantham’s firm GMO publishes a monthly seven-year market forecast. According to Ben 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 September 30, 2013, GMO’s 7-year forecast is below:

US Large -2.0% Intl Large 1.9%
US Small -3.8% Intl Small 1.6%
US High Quality 3.3% Emerging 6.5%
US Bonds 0.3% Inflation Linked Bonds 0.3%
Intl Bonds Hedged -2.0% Cash -0.4%
Emerging Debt 2.7%
Timber 5.9%

Source: https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBDVLb6g8lbKzC5OTwNJieJnCFo6Pc6gcycSMDOY9x9jmayrwKaLIb2T6S86QFct8frDP182Q%2byfbzxzid6ANHmgREvMBV7oKc%3d

GMO expected US large cap real return is -2.0%. This number does not agree with what we find out with market/GDP ratio and Shiller P/E ratio. The US high quality’s return is expected to be 3.3% 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 of 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 1.6-2.5% 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 company's 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 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 market is way over valued, stay in cash. You may consider hedging or short.

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Rating: 4.3/5 (12 votes)


ComLP - 4 years ago    Report SPAM
Fantastic! Thanks for a very good article with a lot of good content to ponder.

It's alarming - at least to me - how every indicator is pointing to the market being overvalued. At the same time a lot of prominent investors are speaking of their concerns. I've practically gone from being quite optimistic - probably due to good performance and a belief that the world economy is recovering - to being fearful of future events.

I'm not in the business of having to compete for relative performance and I'm sure must Gurufocus users aren't. Personally I've gone from 100% invested in equities to a 10% position in cash and gold respectively. Anxiously waiting for the new year to come (tax reasons), so I can balance my portfolio even more defensively.

What is everyone else doing? Are you feeling greedy, fearful or...?

In closing I'll paraphrase Seth Klarman:

"Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals--recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the U.S.-- isthe riskiest environment of all."

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