The market was up more than 30% in 2013, the best year since the go-go years of 1990s. 2014 was another strong year for the market. The S&P 500 index was up more than 13%. Since the market recovery in 2009, the stock market has been up for 6 consecutive years. Yet in January 2015, the stock market benchmark S&P 500 lost 3.10%. In February, the market regained its strength by increasing 5.49%. Throughout March, the market went down by 1.74%. In April and May, the market was up by 0.85% and 1.05% separately.
Bernard Baruch once said, “A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.”
Carl Icahn tweeted on June 24, “I believe the market is extremely overheated – especially high yield bonds. If more respected investors had warned about the market in ’07, we might have avoided the crisis in ’08.” He told CNBC's Fast Money Halftime Report "I think the public is walking into a trap again as they did in 2007" and "I think it's almost the duty of well-respected investors, like myself I hope, to warn people, to tell people that really you are making errors."
Robert Shiller, who popularized the cyclically adjusted price-to-earnings ratio (commonly known as Shiller P/E), is also thinking about exiting U.S. stocks and getting into Europe. He said in a television appearance on 2/18/2015 “I'm thinking of getting out of the United States somewhat. Europe is so much cheaper.” Specifically, Shiller has already purchased stock indices in Spain and Italy.
Leon Cooperman wrote in an investor letter in January this year remained bullish on the U.S., while predicting bigger gains elsewhere. He said “We expect the European and Japanese equity markets to outperform the U.S. in the coming year.”
David Einhorn, the founder and president of Greenlight Capital, has “scaled back wagers on stock gains after markets climbed and as a stronger dollar threatens to limit earnings of U.S. companies from operations overseas,” according to Bloomberg. “Bets on rising assets exceeded short wagers by 38.9 percentage points as of December 31, Greenlight Capital Re Ltd., said in a filing Tuesday. That compares with net-long exposure of 40 percent on Sept. 30 and 53.9 percent at the end of 2013.”
"The negatives we see include stretched valuations and earnings headwinds later this year, including a strong dollar, which reduces the translated earnings of foreign subsidiaries,” Einhorn said Wednesday on a conference call discussing the reinsurer’s results. “From a macro perspective, we are worried that emergency policies are now failing.”
In Daniel Loeb's Third Point First Quarter 2015 Investor Letter, he remained constructive on the U.S.:
“In the U.S., markets have been mixed as investors await the Fed’s looming rate hike and worry about dollar strength impacting earnings and the economy.
"We remain constructive on the U.S. for three reasons: 1) economic data should improve in the next few quarters; 2) the Fed does not seem to be in any rush to move early and a June rate hike seems unlikely; and 3) while investors are focused solely on the first rate raise, we think the overall path higher will be gradual, in contrast to previous rate shifts. These factors should create an environment where growth improves and monetary policy stays flexible, which is generally good for equities (higher multiples notwithstanding). We may follow last year’s playbook and ignore the old adage to 'sell in May and go away.'”
In Bill Frels’ Mairs & Power Growth Fund Q1 2015 Commentary, he remained positive in the long-term, but was more cautious on the direction of the market near-term:
“We are more cautious on the direction of the market near-term due to the disruptive effects of the stronger dollar and the likelihood of higher interest rates. Longer term, however, we remain quite positive. The balance sheets of companies across the S&P 500 are very clean with low debt to total assets, giving them significant capacity to invest in their businesses, grow dividends and buy back stock. Following the success of the U.S. economic recovery, slow and uneven as it has been, many foreign governments are following the U.S. example by adopting more accommodative monetary policies and pumping money into the system to stimulate their economies. We believe this will ultimately improve the outlook for growth internationally, particularly in Europe and Japan. As international economies strengthen, the currency imbalance will self-correct, benefiting the same companies that currently are hurt by the stronger dollar.
"As always, our approach is to stick with the names we like long term, buy stocks that we believe have been excessively beaten down and trim positions that we see as fully valued. While it may take some time before the full benefits of our investment approach are seen, we believe it is the way to build wealth for long-term investors.”
In John Keeley’s KEELEY Small Cap Value Fund Q1 2015 Commentary, it mentioned:
“Overall, despite uncertainty with respect to the Fed interest rate decision, currency markets, and energy prices, we believe the economic backdrop is favorable for equities. Earnings should be stable and we continue to believe we are in a low inflation, moderate growth environment. However, it is dif cult to not expect volatility due to the potential impact of the factors mentioned earlier. We anticipate that the broad nature of these factors will be far reaching and produce volatility across different countries, companies, and industries. This should produce a broad range of opportunities for active stock selection. We also believe that with the window closing on the low interest rate environment that companies have enjoyed in recent years, many companies will seek strategic alternatives before rates begin to rise. This could potentially foster more financial engineering in the short term, including many themes that resonate with our investment philosophy such as spinoffs, corporate actions, divestitures and industry consolidations, to name a few. We believe these actions can be a catalyst to uncover attractively priced investment ideas that can generate alpha for our funds over the long term.”
In Robert Olstein’s All Cap Value Fund’s Q1 2015 Letter to Shareholders, he said:
“The expectation of rising interest rates, the strengthening of the US dollar and weaker-than-expected economic data led to an increase in market volatility during the first quarter of the year. The volatility was further fueled by forecasters’ predictions of a market pullback in the near future. While there are always forecasters predicting the next market correction or downturn (it eventually does occur), we believe it is important to weather market events and periods of short- term volatility by favoring the equities of financially strong companies with stable or growing free cash flow, run by managements that have demonstrated a history of deploying company excess cash to the benefit of shareholders.
"Although alluring, we continue to believe that market timing is a low probability game and we are focusing on individual companies whose real economic value is, in our opinion, unrecognized by the market, and obscured by market uncertainty or overshadowed by temporary problems. Over the long run, focusing on companies whose long-term values are unrecognized by the market because of temporary factors has served our shareholders well. We are continuing to find what we believe to be viable undervalued opportunities by focusing on three primary, company-specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to generate sustainable free cash flow; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders. We further believe that by prioritizing these factors, our portfolio of companies should be positioned to compete more advantageously as economic growth accelerates.”
In John Hussman’s commentary on June 15, 2015, “When You Look Back On This Moment In History,” he mentioned:
“When you look back on this moment in history, remember that spectacular extremes in reliable valuation measures already told you how the story would end.
"When you look back on this moment in history, remember that the valuation of the median stock was never higher. Ever. Even at the 2000 peak.
"When you look back on this moment in history, remember that S&P 500 returns had never materially exceeded zero over the decade following similar valuations.
"When you look back on this moment in history, remember that rich valuations had not only been associated with low subsequent market returns, but also with magnified risk of deep interim price losses over shorter horizons.
"When you look back on this moment in history, remember that dismal return/risk prospects were grounded in objective historical evidence, not simply opinion.
"When you look back on this moment in history, remember that extreme valuations had already been joined by deterioration in market internals and credit spreads.
"When you look back on this moment in history, remember that the strongest historical prerequisites for a market crash were already in place.
"When you look back on this moment in history, remember that many investors ruled out the possibility of major losses over the completion of the current market cycle because they presumed relationships that could not be established in the data, and assumed the absence of any material economic or financial shock in the coming years.
"When you look back on this moment in history, remember that the popular 'Fed Model' was a statistical artifact, not a 'fair value' relationship.
"When you look back on this moment in history, remember that many investors implicitly believed that depressed interest rates and high valuations were good for future stock market returns.
"When you look back on this moment in history, understand that all of this evidence was freely available.”
In GMO Q1 2015 Letter –Â 'Are We The Stranded Asset?'Â Jeremy Grantham said:
“A brief update on the U.S. market: still not bubbling yet, but I think it will.
"To remind you, we at GMO still believe that bubble territory for the S&P 500 is about 2250 on our traditional assumption that a two-sigma event, based on historical price data only, is a good definition of a bubble. (As we like to describe it, arbitrary but reasonable, for it fits the historical patterns nicely.)
"For the record, probably the best two measures of market value – Shiller P/E and Tobin’s Q – have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively. So, just as with the price-only series, they are also well on the way to bubble-dom but, clearly enough, not there yet. If we used these value series instead of just price it would add 5-10% to the bubble threshold, further improving my case that the current market still has a way to go before reaching bubble territory. Historically, we have often used the price series as both less judgmental than using measures of value, and as a much fairer comparison with other bubbles (e.g., commodities currencies and housing).
"We could easily, of course, have a normal, modest bear market, down 10-20%, given all of the global troubles we have. If we do, then the odds of this super-cycle bull market lasting until the election would go from pretty good to even better. So, '2250, here we come' is still my view of the most likely track, but foreign markets are of course to be preferred if you believe our numbers. Stay tuned.”
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 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 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 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 Ccap over GDP –Â 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 June 26, 2015, the total market cap as measured by Wilshire 5000 index is 125.7% 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 0.1% 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 2014, the ratio of total market cap over GDP was 115. Its historical mean is around 85%.
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 June 24, 2015)
As of June 24, 2015, the ratio of Wilshire 5000 over GNP is 1.252.
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 5.0% a year or as low as -7.7% 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 –Â Market valuation and implied returns
The GuruFocus Shiller P/E page indicates that the Shiller P/E is 27. This is 62.7% higher than the historical mean of 16.6. Implied future annual return is -0.3%. 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.
John Hussman’s peak P/E:
John Hussman currently estimates nominal total returns of roughly 0% annually for the S&P 500 over the coming decade.
In John Hussman’ commentary on June 22, 2015, “All Their Eggs in Janet's Basket,” he said, “The financial markets are establishing an extreme that we expect investors will remember for the remainder of history, joining other memorable peers that include 1906, 1929, 1937, 1966, 1972, 2000 and 2007. The failure to recognize this moment as historic is largely because investors have been urged to believe things that aren’t true, have never been true and can be demonstrated to be untrue across a century of history. The broad market has been in an extended distribution process for nearly a year (during which the NYSE Composite has gone nowhere) yet every marginal high or brief market burst seems infinitely important from a short-sighted perspective. Like other major peaks throughout history, we expect that these minor details will be forgotten within the sheer scope of what follows. And like other historical extremes, the beliefs that enable them are widely embraced as common knowledge, though there is always, always, some wrinkle that makes “this time” seem different. That is why history only rhymes. But in its broad refrain, this time is not different.”
“As a reminder of where valuations stand, the following chart presents the ratio of market capitalization to non-financial gross value added, including estimated foreign revenue. MarketCap/GVA has a correlation of 92% with actual subsequent S&P 500 total returns over the following decade, a reliability that exceeds that of every other valuation ratio we’ve examined across history, including price/forward earnings, the Fed Model, the Shiller P/E, Tobin’s Q, market cap/GDP, dividend yields, price/book, and even price/revenue.”
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. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only -0.3-0.1% annually in the future years.
Jeremy Grantham’s seven-year projection:
In GMO Q1 2015 Letter - 'Are We The Stranded Asset?', Jeremy Grantham said as I quote:
“A brief update on the U.S. market: still not bubbling yet, but I think it will
"1: The key point here is that in our strange, manipulated world, as long as the Fed is on the side of a strong market there is considerable hope for the bulls. In the Greenspan/Bernanke/Yellen Era, the Fed historically did not stop its asset price pushing until fully-fledged bubbles had occurred, as they did in U.S. growth stocks in 2000 and in U.S. housing in 2006. Both of these were in fact stunning three-sigma events, by far the biggest equity bubble and housing bubble in U.S. history. Yellen, like both of her predecessors, has bragged about the Fed’s role in pushing up asset prices in order to get a wealth effect. Thus far, she seems to also share their view on feeling no responsibility to interfere with any asset bubble that may form. For me, recognizing the power of the Fed to move assets (although desperately limited power to boost the economy), it seems logical to assume that absent a major international economic accident, the current Fed is bound and determined to continue stimulating asset prices until we once again have a fully fledged bubble. And we are not there yet.
"2: To remind you, we at GMO still believe that bubble territory for the S&P 500 is about 2250 on our traditional assumption that a two-sigma event, based on historical price data only, is a good definition of a bubble. (As we like to describe it, arbitrary but reasonable, for it fits the historical patterns nicely.)
"3: For the record, probably the best two measures of market value – Shiller P/E and Tobin’s Q – have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively. So, just as with the price-only series, they are also well on the way to bubble-dom but, clearly enough, not there yet. If we used these value series instead of just price it would add 5-10% to the bubble threshold, further improving my case that the current market still has a way to go before reaching bubble territory. Historically, we have often used the price series as both less judgmental than using measures of value, and as a much fairer comparison with other bubbles (e.g., commodities currencies and housing).
"4. We could easily, of course, have a normal, modest bear market, down 10-20%, given all of the global troubles we have. If we do, then the odds of this super-cycle bull market lasting until the election would go from pretty good to even better. So, '2250, here we come' is still my view of the most likely track, but foreign markets are of course to be preferred if you believe our numbers. Stay tuned.”
As of May 31, 2015, GMO’s 7-year forecast is below:
| Stocks | Â | Â | Â |
| U.S. Large | -2.3% | Intl Large | -0.7% |
| U.S. Small | -3.0% | Intl Small | -1.3% |
| U.S. High Quality | 0.2% | Emerging | 3.0% |
| Bonds | Â | Â | Â |
| U.S. Bonds | -1.1% | Inflation Linked Bonds | -0.2% |
| Intl Bonds Hedged | -3.2% | Cash | -0.5% |
| Emerging Debt | 1.9% | Â | Â |
| Other | Â | Â | Â |
| Timber | 4.8% | Â | Â |
GMO expected U.S. large cap real return is -2.3%. This number is similar 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 only 0.2% 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.
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 U.S. stock market value to U.S. net assets at replacement cost since 1950.
The GuruFocus Economic Indicator Tobin Q page indicates that the Q ratio is 1.06 as of January 1, 2015. This is 49.3% 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 $132.63 billion as of December 31, 2014. According to S&P Dow Jones Indices press release, “S&P 500 fourth quarter 2014 stock buybacks, or share repurchases, decreased 8.7% to $132.6 billion down from the $145.2 billion spent on share repurchases during the third quarter of this year. The $132.6 billion Q4 spend represents a 2.5% increase from the $129.4 billion spent during the fourth quarter of 2013. For the fiscal year 2014, S&P 500 issues increased their buyback expenditures by 16.3% to $553.3 billion from $475.6 billion posted in 2013. The high mark was reached in 2007, when companies spent $589.1 billion. The recession low point was $137.6 billion, recorded in 2009.”
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.
Conclusion: The stock market is not cheap as measured by long term valuation ratios. It is positioned for about -0.3-0.1% 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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