August was undoubtedly a tough month for the market, with share prices plunging on Aug. 18 and leading to a selloff on Aug. 21, reaching what some consider the first meaningful correction in years.
At the close of trading on Aug. 21, the S&P 500 fell 3.2% or 64.84 points to 1,970.89. According to the S&P Dow Jones Indices, the index lost $1.14 trillion in value that week. The DJIA was down 530.94 points to 16,459.75. Macro concerns that may have led to the selloff include Greece’s ongoing financial troubles, including its default on an IMF loan on June 30. China’s economic instability, however, gradually overtook Greece in the headlines, and was also blamed for spooking investors, as the country unexpectedly devalued its currency.
Moreover, even renowned stock pickers are reporting losses for the month and year-to-date. The New York Times reported David Einhorn (Trades, Portfolio)’s Greenlight Capital was down 5.3% in August and 14% so far this year. Leon Cooperman (Trades, Portfolio) of Omega Advisors was also down 11% for the month, blaming risk parity portfolios and strategies for the market volatility in his August letter.
“We think that much of that decline can be attributed to systematic/technical investors that are price-insensitive and largely indifferent to fundamentals,” Cooperman wrote. “Such investors include risk-parity funds, derivative hedgers, trend-following CTA's, and insurance variable-annuity programs.”
Bill Ackman (Trades, Portfolio) said Pershing Square was down 7.3% for the quarter and 4.3% for the year, again due to significant volatility in the global markets. Even the world’s largest hedge fund, Ray Dalio (Trades, Portfolio)’s Bridgewater Associates, was down 4.77% as of Aug. 25.
GuruFocus offers several features to help investors analyze market valuations. One features the market valuation based on the ratio of total market cap over GNP, which Warren Buffett (Trades, Portfolio) has said is “probably the best single measure of where valuations stand at any given moment.”
As of today, the total market index is 114.1% of the most recently reported GDP, positioning the market for an average annualized return of 1.3% based on historical valuations.
The source of investment returns are determined by three factors: business growth, dividends, and change in the market valuation. Using these factors, the return of an investment can be estimated by the following formula:
Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
The third variable in the equation can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated as:
(Re/Rb)(1/T)-1
Therefore, the investment return equation is equal to:
Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1
In GuruFocus’ calculations, the time period used is eight years, as this is about the length of a full economic cycle. The yellow line in the graph below depicts the actual annualized return of the market over eight years, using the Wilshire 5000 Full Cap Price Index. The green line shows expected returns if the market is undervalued over the next eight years (TMC/GNP=40%), the red line indicates returns if the market is overvalued (TMC/GNP=120%), and the blue line shows expected returns if the market trends toward fairly valued (TMC/GNP=80%).
The chart below depicts the ratio of the Wilshire 5000 over GNP, with recession periods highlighted in white.
Another market valuation indicator is the Shiller P/E invented by Yale economist Robert Shiller, which eliminates fluctuation of the ratio caused by profit margin variations during business cycles. As of today, the Shiller P/E is 24.3, which is 46.4% higher than the historical mean of 16.6.
Based on several long-term valuation methods, it’s clear that the U.S. market is expensive. Investing options during times like these include staying in cash and continuing to buy high-quality companies, such as those that appear in the Buffett-Munger Screener.
Despite hard times in the last month, David Herro (Trades, Portfolio) of the Oakmark Funds wrote in his second quarter market commentary that not all was bad news in the global economy.
“Despite the negative impact of events in Greece… the estimate for Eurozone growth was recently lifted to +1.5% from +0.9%,” Herro wrote. “The impact of structural reform, as well as lower energy costs, a looser monetary policy and a weaker European currency are finally beginning to have a positive impact on the European economy.”
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