Many investors would love to predict the market to know whether the market is on the uptrend or downtrend. It’s really hard to do, and I personally think it’s impossible to predict the market, especially in a short-term. However, it is possible and useful to have a general idea of whether the overall market is overvalued, fairly valued or undervalued. We don’t need to know the absolute number to determine the state of the market, but we can have the feel for it. Benjamin Graham, the father of value investing, has said: “You don’t have to know a man’s exact weight to know that he’s fat.”
Warren Buffett (Trades, Portfolio) has given us the ratio that he uses to determine the attractiveness of general market. It’s the ratio of total market capitalization of all U.S. public traded companies to the country's GNP. Buffett has said “The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.” He recommended buying into the market when the ratio falls into the 70% to 80% area. But if investors buy into the market when the ratio reaches 200%, like the market condition in 1999, investors are “playing with fire.”
Investors may use either GNP or GDP, because the two numbers are not of great difference.
Since GuruFocus updates this ratio daily, investors do not have to go to find the two numbers every single day. As of today, the total market capitalization to U.S. GDP is 108.7%, which falls into the modestly overvalued level.
However, with a lot of unprecedented situations including negative interest rates, many investors worry. Prem Watsa (Trades, Portfolio), the so-called Canadian Warren Buffett (Trades, Portfolio) and chairman of Fairfax Financial Holdings (TSX:FFH, Financial), has added $938 million in short positions and derivatives, increasing his portfolio hedge from 88% to 100%. So Prem Watsa (Trades, Portfolio)’s investment portfolio is totally hedged now. The reason is because he is concerned about the deflation situation of global economy.
Jeffrey Gundlach, the "Bond King," also showed his pessimism on the market. In the DoubleLine presentation, he showed the correlation between junk bonds and S&P 500.
Source: DoubleLine presentation
In the above slide, the black line is the S&P 500 and the blue line is high yield spreads inverted. When the blue line goes down, this means that the high yields are rising and high yield prices are falling. Gundlach explained the chart carefully in the presentation. In 1998, junk bond prices crashed, around two years before the dot-com market peak. In the 2008 crash, the situation was similar. The junk bonds peak sooner, then the stock market bursts to join the junk bond at the very low level. As the junk bond market began to crash around 18 months ago, either the S&P 500 would decline or the high yield price would rise. But history has taught us that the probability of the S&P 500 decline to meet the high yield market at lower levels is quite high.
In conclusion, the general market might drop in the short-term, but if investors can get in high return businesses at a reasonable valuation, they can compound their money at a decent rate over time.
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