The stock market indices didn’t do much themselves in 2015. Among S&P 500 companies, slightly more companies were down than up. Energy companies, miners were the worst performers in 2015. The best performers were the high fliers such as Netflix (NFLX, Financial), which was up more than 134%, and Amazon (AMZN, Financial), up 117%.
Market Valuations as Measured by the Buffett Indicator
The most important indicator of the stock market valuation is what we called Buffett-indicator. It is the ratio of total market cap over GNP. As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”
This the historical value of the ratio:
As of today, the ratio is standing at 114.3%. If we assume the ratio will revert to the mean in 8 years, the market will average exactly 1% of return over the next 8 years, including dividends.
This seems very pessimistic. But the ratio has been quite accurate in predicting long term market returns, as indicated in the chart below:
The blue line in the above chart is the prediction based on the ratio of Total Market Cap over GNP will be it is historical mean in 8 years, while the red line is the extreme optimistic case, which gives a potential return of 6% a year over the next 8 years. The green line is the pessimistic case, which gives an return of -6.5% a year over the next years. The yellow line is the actually return, which has pretty good agreement with the blue line.
For more details of Buffett indicator and how we arrived at these numbers, please visitor Where Are We with Market Valuations?
Shiller P/E Ratio and Its Predictions
Shiller P/E, named after its invention Prof. Robert Shiller of Yale University, is another more objective measurement of the market valuation. As of today, it sits at 25.3, which is about 51.5% higher than the historical mean of 16.7.
This is the historical value of Shiller P/E:
Shiller P/E certainly indicates that the market is wildly overvalued. Historically only three periods the ratio was higher, the bubble of 1929, the tech bubble of 1999 and the financial bubble of 2007. The regular P/E is 21, which is also much higher the historical mean of 15.9.
We can use the similar revert to the mean methodology to calculate potential market returns. At today’s Shiller P/E, the market is likely to return 0.3% a year over the next 8 years, which is similar to the conclusion we reached from the Buffett indicator.
To learn more about Shiller P/E, please go here.
The Risks Today Are Substantial – Howard Marks (Trades, Portfolio)
In a recent interview Howard Marks (Trades, Portfolio), the chairman of Oaktree Capital, one of the most successful investors on Wall Street, thinks that the chance for recession is low. But the market poses great risk, mostly from China.
“Security prices are not low. I wouldn’t say high but full. So people are thinking cautiously but they’re acting bullish, and they’re behaving in a pro-risk fashion.” He said.
How about the chance of a 2016 recession? “I think we’re going to limp along in a slow growth mode. There is always a possibility of some acceleration. But there is no boom so there is no need for a bust. Booms usually create overexpansion and when it turns out that it was excessive it turns into a bust. Today, I don’t see boom and I don’t see bust. So I don’t see anything that could cause a recession in the short term, at least not in 2016 – and I’m not characterized an optimist.”
John Hussman (Trades, Portfolio) of Hussman Funds has started to warn investors of the risk of a potential recession. He has pretty good track record for predicting recessions. But Chemical Activity Barometer, which has historically been a very good leading indicator of the economy, shows no sign of slowing down:
Though corporate profit margin has declined as they did before every recession:
Insider Trends
Insider trends ars a great indicator of what insiders are thinking about the valuations. You can learn more about insider trends here.
Overall, insiders were bullish than average in December:
Sector/Industry Valuation
The poor performance of energy sector has driven the valuation of energy companies to the lowest in market. The median P/E of the sector is now 5.7 for oil & gas drillers, and 9.44 for E&P companies. As the consequence, the median dividend yields of these companies are now above 5.44%.
Being out of favor like this, patient investors may be able to find some real bargains. The companies with good dividend coverage are good bets for income investors, too. One such example is Alliance Resource Partners LP (ARLP, Financial), the stock was down two thirds in 2015. The dividend yield is now close to 20%. The company still has pretty good dividend coverage. Of course, the ride won’t be smooth, but it might be worth the bet.
This is the historical dividend coverage for Alliance Resource Partners LP:
Among all sectors, the most expensive ones are biotech and online media. The median P/E in these industries is above 33, and the dividend yields are less than 2%.
You can see the sector/industry valuation distribution in GuruFocus page of Industry Overview: Valuation, Dividend Yield, Growth and Profitability
Junk Bond Yield Continues to Rise
There are warning signs in the bond market. The junk bond has been rising. The yield is now its highest level in 6 years. BofA Merrill Lynch US High Yield CCC now yields 16.53%. This is something investors should keep an eye on. For historical yields, please look at the chart below:
