In January 2014, the S&P 500 lost 3.36% after an excellent 2013. The enthusiasm came back as the market gained 4.31% over February. In March, it was essentially flat. In April, it was about even for the whole month. In May, the market gained 2.1% and in June, the S&P 500 went up 1.91%. In July, the market went down by 1.51%. However, the market gained 3.77% over August, which was the second-biggest monthly gain since 2014. Throughout October, the market benchmark S&P 500 earned 2.32% after the decline of 1.55% in September.
Despite S&P 500 declining 1.32% on the first day of October, billionaire investor Warren Buffett told CNBC on Thursday he bought stocks in Wednesday's big selloff. Buffett said he likes to buy stocks when they go down, not when they go up. “The more it goes down, the more I like to buy.” He said he buys businesses that he thinks will be good for the next 50 years, such as the deal to buy the nation's largest privately held car dealership group, Van Tuyl Group.
In Daniel Loeb’s Third Point Q3 2014 Investor Letter, he gives some perspectives on the current market environment:
“Going forward, we expect that the US will remain the best place to invest, credit opportunities will stay slim, and large cap opportunities with a constructivist angle will become more promising. Although consensus has shifted to lower growth, slower inflation, modest rates, and continued monetary expansion, we think the markets will resume an overall upward trajectory in the US through year-end.”
In Brian Rogers’ T Rowe Price Equity Income Fund Q3 2014 Commentary, he gives cautious outlook on the equity market:
“We maintain our cautious outlook as the equity market continued its upward path during the year. The equity market runup since 2011 has come on the back of accommodative Fed policy, historically high profit margins, and general multiple expansions. Current equity market valuations are roughly in line with their long-term averages, so we expect a closer focus on company fundamentals going forward. Wage growth and single-family housing remain tepid, suggesting weak aggregate demand. We believe that equity returns will continue to moderate in the coming months, as prices have risen to the point where values are more difficult to find. In addition, there are a number of unpredictable areas of geopolitical tension that could rattle investor confidence at some point, and we prefer to err on the side of caution after an extended period of strong stock performance.”
In Ron Baron’s Q3 2014 Review and Outlook, he said:
“Despite all the good news about our economy, we believe that global political uncertainties are the principal reason stock prices do not exceed their median levels of the past hundred years. U.S. equities are presently valued at around 15.2X 2014 earnings. The normal range in which stocks have traded for most of the past 100 years is 10X to 20X earnings. Rarely above. Rarely below. Further, stock prices are inextricably linked to our economy. In September 2014, the Dow Jones Industrial Average topped 17,000. U.S. GDP is expected to reach $17 trillion this year. In 2007, the Dow Jones Industrial Average was 14,000.The nation’s GDP was $14 trillion. In 1960, when Kennedy became president, the Dow Jones Industrial Average was 600. The nation’s GDP was $520 billion, less than the value of Apple today! Our nation’s economy has grown at a compound annual rate of 6.7% per year in nominal terms since 1960. Our stock market has grown at an annual rate of 6.4% per year. When annual dividends of approximately 2% are added to stock appreciation, stock prices have approximately doubled every 10 years for the past 55 years. We see no reason that our nation’s economy and stock markets will not continue to achieve these historic results over the long term.” He also mentioned “Berkshire Hathaway’s recent purchase of a large new car dealership indicates that investor Warren Buffett is optimistic not only about the possibility of Berkshire’s ability to “roll up” other auto dealers and provide car financing. He clearly also believes that a high level of new car purchases can be sustained since the average age of cars on the road has reached 11.2 years, and disposable household income is improving. When I became an investment analyst in 1970, the average age of cars in America was seven years!”
In John Hussman's commentary Do the Lessons of History No Longer Apply?, he said:
“On the most reliable measures, we estimate that S&P 500 valuations are now only about 15-20% short of the 2000 extreme, and are clearly above every other extreme in history including 1901, 1929, 1937, 1972, 1987, and 2007. As of last week, based on a variety of methods, we estimate likely S&P 500 10-year nominal total returns averaging just 1.5% annually over the coming decade, with negative expected returns on every horizon shorter than about 8 years. Given the full weight of the evidence, it should be clear that one can’t just say “well, look, the S&P 500 has done better than these models would have projected a decade ago,” and use that as a compelling argument that this time is different and historical regularities no longer hold. Quite the opposite – the overshoot in S&P 500 total returns since 2004 – relative to the prospective returns one would have estimated at the time – is highly informative that stocks are strenuously overvalued at present. That conclusion has strong statistical support.”
In Tweedy Browne’s Q3 2014 Commentary, he mentioned:
“While we were somewhat chagrined to see our oil stocks take it on the chin over the last quarter, we welcomed the increase in market volatility. As Warren Buffett (Trades, Portfolio) has said on numerous occasions, including just the other day, a long term consumer of equity securities should welcome pullbacks in equity markets, which afford them the opportunity to buy interests in businesses at attractive prices. We absolutely concur. While valuations in public equity markets still remain relatively full, we are quite confident that new opportunities will present themselves if we continue to be diligent and remain patient.”
In Jeremy Grantham’s GMO Second Quarter 2014 Letter, he mentioned:
“Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect. What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. The very disappointment in the rate of recovery thus becomes a virtue for deal making. Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed. My final thought on this issue is the following point, which I failed to make in my bubble discussion last quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of a bubble in the quantity of credit that was being created.”
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.
According to our market valuation article at the beginning of 2014, Buffett Indicator and Shiller P/E Both Imply Long Term Negative Market Returns; 2014 Market Valuation, 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.
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 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 the international market.
Why is this important?
As Warren Buffett pointed out, the percentage of total market cap 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.
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 2001-2002 and 2008-2009, 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 find 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. As of November 11, 2014, the total market cap as measured by Wilshire 5000 index is 126% of the U.S. GDP. We can see the equity values as the percentage of GDP are near their peaks. The only time they were higher was at the apex of the dot com bubble. The stock market is likely to return 0.8% a year from this level of valuation, including dividends in the coming years. The stock market is significantly overvalued. 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.
A quick refresher (Thanks to Greenbacked): GDP is “the total market value of goods and services produced within the borders of a country.” GNP is “is the total market value of goods and services produced by the residents of a country, even if they’re living abroad. So if a U.S. resident earns money from an investment overseas, that value would be included in GNP (but not GDP).”
The following chart is the Ratio of Total Market Cap over GNP (As of September 30, 2014)
As of September 30, 2014, the ratio of Wilshire 5000 over GNP is 1.183.
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 5.7% a year or as low as -7.1% 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 26.6. This is 60.2% higher than the historical mean of 16.6. Implied future annual return is 0.6%. The historical low for Shiller P/E is 4.8, while the historical high is 44.2.
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.
Tobin’s Q
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. He hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs.
The following graph is Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1950.
The GuruFocus Economic Indicator Tobin Q page indicates that the Q ratio is 1.120 as of April 1, 2014. This is 57.3% higher than the historical mean of 0.71. Latest Q ratio is now the second highest in history, just following the peak of the Tech Bubble.
If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. The market may be overvaluing the company.
S&P 500 Quarterly Buybacks
The GuruFocus Economic Indicator S&P 500 Quarterly Buybacks page indicates that the preliminary S&P 500 quarter buybacks is $116.17 billion as of June 30, 2014. According to S&P Dow Jones Indices press release, “the preliminary results show that S&P 500 stock buybacks, or share repurchases, decreased 1.6% to $116.2 billion during the second quarter of 2014, down from the $118.1 billion spent on share repurchases during the second quarter of 2013. The $116.2 billion also represents a 27.1% decline over the $159.3 billion spent on stock buybacks during Q1 2014, which was the second largest on record.” The slowdown in buybacks is a negative sign for the U.S. stock market. Share repurchases are the main way companies reduce the float of shares. Perhaps fewer companies like what they see when they look into the future.
The following chart is the S&P 500 quarterly buybacks since 2000 to present.
John Hussman’s Peak P/E:
John Hussman currently estimates prospective 10-year nominal total returns about 1.5% annually, with negative expected total returns on every horizon shorter than eight years.
In John Hussman’s commentary on November 10, 2014, “Do the Lessons of History No Longer Apply?” he said “The charts below show several of the measures that have the strongest relationship (correlation near 90%) with actual subsequent 10-year S&P 500 total returns, reflecting data from the Federal Reserve, Standard & Poors, Robert Shiller, and valuation models that we have published over the years. The first chart shows these measures as the percentage deviation from their historical norms prior to the late-1990’s equity bubble. While it’s easy to lose sight of the extremity of the present situation, these measures are well over 100% above their respective norms, on average. On the most reliable measures, we estimate that S&P 500 valuations are now only about 15-20% short of the 2000 extreme, and are clearly above every other extreme in history including 1901, 1929, 1937, 1972, 1987, and 2007. Again, these measures are also better correlated with actual subsequent market returns than popular alternatives such as price/forward operating earnings and the Fed Model (which adjusts the S&P 500 forward operating earnings yield by the level of 10-year Treasury yields).”
“As of last week, based on a variety of methods, we estimate likely S&P 500 10-year nominal total returns averaging just 1.5% annually over the coming decade, with negative expected returns on every horizon shorter than about 8 years. The chart below shows the historical record of these estimates (in percent) versus actual subsequent 10-year S&P 500 total returns. What’s notable is not only the strong correlation between estimated returns and actual subsequent returns, but also that the errors are informative.”
“Given the full weight of the evidence, it should be clear that one can’t just say “well, look, the S&P 500 has done better than these models would have projected a decade ago,” and use that as a compelling argument that this time is different and historical regularities no longer hold. Quite the opposite – the overshoot in S&P 500 total returns since 2004 – relative to the prospective returns one would have estimated at the time – is highly informative that stocks are strenuously overvalued at present. That conclusion has strong statistical support. In fact, when we examine the historical evidence, we find that there’s a -68% correlation between the error in the projected return over the past decade and the actual subsequent total return of the S&P 500 in the following decade. That is, the more actual 10-year S&P 500 returns exceeded the return that was projected, the worse the S&P 500 generally did over the next 10 years. Notably, the “Fed Model” has a correlation of less than 48% with actual subsequent 10-year returns. It’s sad when a valuation measure that is so popular is outperformed even by the errors of better measures.”
In all the 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, Tobin’s Q, or buybacks. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only 0.6-1.5% annually in the future years.
Jeremy Grantham’s 7-Year Projection:
In Looking for Bubbles and In Defense of Risk Aversion, Jeremy Grantham said “we are far off the pace still on both of the two most reliable indicators of value: Tobin’s Q (price to replacement cost) and Shiller P/E (current price to the last 10 years of inflation-adjusted earnings). Both were only about a 1.4-sigma event at the end of March. (This is admittedly because the hurdle has been increased by the recent remarkable Greenspan bubbles of 2000 and a generally overpriced last 16 years.) To get to 2-sigma in our current congenitally overstimulated world would take a move in the S&P 500 to 2,250.”
In GMO Second Quarter 2014 Letter, he said “Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect. What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. The very disappointment in the rate of recovery thus becomes a virtue for deal making. Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed. My final thought on this issue is the following point, which I failed to make in my bubble discussion last quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of a bubble in the quantity of credit that was being created.”
As of September 30, 2014, GMO’s 7-year forecast is below:
| Stocks | Â | Â | Â |
| US Large | -1.5% | Intl Large | 0.8% |
| US Small | -4.1% | Intl Small | 1.0% |
| US High Quality | 2.2% | Emerging | 3.7% |
| Bonds | Â | Â | Â |
| US Bonds | -0.2% | Inflation Linked Bonds | 0.3% |
| Intl Bonds Hedged | -2.9% | Cash | -0.4% |
| Emerging Debt | 2.2% | Â | Â |
| Other | Â | Â | Â |
| Timber | 5.4% | Â | Â |
Source:
GMO expected US large cap real return is -1.5%. 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 2.2% 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 0.6-1.5% 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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