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Buffett Indicator and Shiller P/E Both Imply Long Term Negative Market Returns; 2014 Market Valuation

January 03, 2014

What a great year it was! The market was up 30%, the best year since the go-go years of 1990s.The good news is that our account balance is higher, investors are more bullish. The bad news is that we will see lower future returns.

So where are we with the market valuation and the expected return starting 2014?

Market Valuations

The ratio of Total Market Cap over GNP, Warren Buffett’s “the best single measure of where valuations stand at any given moment,” is standing at 115%. This ratio is already higher than the pre financial crisis peak of 107% and is higher than any time except for the go-go years of late 1990s, when it reached 141%. Its historical mean is around 85%. The detail is shown in the chart below:


Shiller P/E, the cycle adjusted P/E ratio, is now at 25.6, 55.2% higher than the historical mean of 16.5.


Implied Future Market Returns

If we assume that the ratio of total market cap over GNP (Buffett’s indicator) and Shiller P/E will reverse to their mean over time, which they always did in the past, the future market returns do not look good. Using 8 years as time the market will reverse to its mean, both Buffett’s indicator and Shiller P/E suggest that the stock market will average 1% a year (2% dividends contribution included) over the next 8 years. At 1% of total market return, the market indices will be lower than they are now after 8 years.

For details of the calculation and how these indicators worked in the past, go to:

· Where Are We With Market Valuations?
· Shiller P/E – A Better Measurement Of Market Valuation

This prediction agrees with the 7-year forecast from GMO, the highly respected investment firm founded by legendary investor Jeremy Grantham.

Three Stages of Bull Market, and Three Stages of Bear Market

The implied long term negative market return is never an indicator of short term market movements. In short term the market is driven by animal spirits, which is still running high.

Howard Marks, one of the smartest investors from Oaktree Capital, describes the three stages of a bull market:

· the first, when a few forward-looking people begin to believe things will get better
· the second, when most investors realize improvement is actually underway, and
· the third, when everyone’s sure things will get better forever

He also wrote the three stages of a bear market:

· the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
· the second, when most investors recognize things are deteriorating, and
· the third, when everyone’s convinced things can only get worse

In May 2012, he thought we were at the first stages of bull market: a few forward-looking people begin to believe things will get better. In May 2013, he thought that we were somewhere in the first part of stage two.

After a gain of 30% in 2013, investors are more bullish. We don’t know which stage of bull market Howard Marks thinks we are now, but we believe that we are either at late second stage or early third stage. This is indicated by the ratio of investors’ margin debt over GDP:


Investors are borrowing money to buy stocks. This ratio now is only lower than it was in 2000.

Capital Market Indicators

As a bond investor, Howard Market gets a feel about the capital market in the first hand. One of the important indicators he looks is the easiness of capital, which is measured by BofA Merrill Lynch US High Yield CCC Or Below Option-Adjusted Spread, which now sits at 7.44%, and still going down.


Money is easy these days. The chart below is Chicago Fed National Financial Conditions Leverage Subindex. A value of -0.62 indicate that there are plenty of easy capital flooding the market.


Borrowing is easy, and corporations are enjoying the highest profit margins:


Time is good, though market valuation is high and indicates long term market negative returns. But who cares…

"As long as the music is playing, you've got to get up and dance." – Charles Prince, former CEO of Citigroup.

Rating: 4.8/5 (33 votes)


Superguru1 - 4 years ago    Report SPAM

Very informative and well written article. Thanks Gurufocus.

Praveen Chawla
Praveen Chawla premium member - 4 years ago

Good reminder - by all means dance to the sweet music of upward momentum, but keep an eye on the exit.

Jean-Francois Nobert
Jean-Francois Nobert - 4 years ago    Report SPAM

Great analysis

AlbertaSunwapta - 4 years ago    Report SPAM

An interesting bit of market psychology I've noticed is that media pundits say the market can and probably will go higher because we are not in a "bubble" yet.  

When I first began investing as a kid in the 1970s I rarely if ever read that point of view and definitely not with the noticable frequency I encounter today.  In the past, I believe, market forecasters generally would only talk of a bull market turning bearish, ex today's seemingly mandatory "bubble" requirement that seems to have entered market psychology following the extremes of the past two decades.

Moreover, this seeming requirement for the market to reach bubble proportions before the investing crowd discovers fear of loss is at odds with my perception* of human behavior tending towards a 'new' state of overly 'risk adverseness' after near collamitous events.  

* when I started investing I read everything I could find on the 1920s, the 1929 crash, the Great Depression and the post crash market movements as well as Kondratieff, long waves, etc.  then in the 1980s and 1990s I had 15-20 years first hand experience from Alberta, Canada's commodity driven recession and depression.

JoeMcGraw - 4 years ago    Report SPAM

Enjoyed the article. Good charts.

Awinstone premium member - 4 years ago

I wonder to what extent Globalisation skews the Market Cap to GNP ratio. As an example Apple's full market valuation is included in the market cap number but as a significant part of their sales are non-USA sales the GNP number is understated. As American firms sell more to the world and their profits increase together with their market caps, the GNP number does not increase in line and so with more globalisation the ratio is essentially different from the past. Perhaps looking at total world market caps / world GDP would be a better measure.

Gurufocus premium member - 4 years ago

hi Awinstone, the difference between GDP and GNP is less than 2% overall. We have discussed this here:


AlbertaSunwapta - 4 years ago    Report SPAM
And the data for the US in long past decades also reflected the export nature of the US when it was a key supplier to the world. So one could look back a hundred years to see if there were any impacts. Say the 1920s boom. ;-)


Bringing American Ideas Home - Jan, 1991

"Sadly, he notes the decline in the power of the American economy since 1920, when it mass-produced and sold fully half the manufactured products of the world.

Anything made in America was ..."

Uashraf - 4 years ago    Report SPAM

I will add 1 point to it, all valuation are determined by long term bond rates. in last 100 yrs 10 yr rate averaged 6.6% which is equivalent to average market PE of15. Now bond rates are low around 3% and if i have to predict they will remain low for forseeable future which makes me wonder PE will stay high for while otherwise how can bonds which are considered alternatives to stocks attract capital. Either Interest or market valuation of stocks has to rise to bring back equilibrium. I beleive we live in a different world then we saw prior to crisis. We live in a world of low growth with plenty of liquidity and it has to go somewhere. Question is where?

Funkymonkey - 3 years ago    Report SPAM

Maybe I'm missing something here.

But does this ratio ignore privately owned companies? Further to that, wouldn't the total market cap also increase or decrease dependant upon the amount of IPOs or delistings in any given year?

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