As of Oct. 4, the U.S. stock market’s total market-cap / gross domestic product ratio is 122.2%. Although the market valuation slightly decreased since the Sept. 1 valuations, the U.S. stock market remains significantly overvalued. Based on historical valuations, the expected market return is 0.1% annually at the current valuation level, including dividends.
Buffett’s market valuation metric
Warren Buffett (Trades, Portfolio) claims that the TMV / GDP ratio best measures the current market valuations. The price-sales (P/S) ratio for the entire market measures the size of the Wilshire total market index (TMI) relative to the country’s gross domestic product (GDP). The TMI is currently $22.537 trillion, about 122.2% higher than the U.S. GDP. As the ratio assumes reversion to the mean, the expected market return depends on where the market valuation stands.
Although the valuations historically followed the green pessimistic trendline, the market valuation followed the blue trendline during recent years. Based on the historical valuations, the expected annual market return ranges from -7.8% to 5.0%.
Shiller’s market valuation metric
Unlike the Buffett indicator, the Shiller price-earnings (P/E) ratio measures the market valuation based on total earnings. Since it removes profit margin variation during business cycles, Shiller’s version of the commonly used P/E more accurately measures market valuations than the basic P/E does. While the ratio slightly dropped during September, the Shiller P/E is still significantly higher than the historical mean of 16.7. The ratio implies a future annual return of -0.6%.
Shiller also measures the market valuation for each of the sectors. Although it decreased throughout September, the Shiller P/E for the real estate sector is significantly higher than the Shiller P/E ratios for the other 10 sectors. On the other hand, the energy and financial services sectors have low Shiller P/Es compared to the rest of the sectors. Additionally, the energy sector’s Shiller P/E generally remained constant during the past three years.
Buffett’s asset allocation sheds light on gurus’ market views
Buffett, one of the co-managers of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), currently split the conglomerate’s liquid assets based on the pie chart below.
Since 1995, Berkshire Hathaway generally had over half of its assets in equity securities (stocks). Occasionally, stocks represent over three-quarters of the conglomerate’s assets, especially before 1998, when it sharply declined to 53%. Although Buffett gradually increased its equity allocations over the next 15 years, the managers have decreased their allocations in stocks since 2014. Despite this, Buffett is still relatively bullish on stocks.
On the other hand, Buffett has been bearish on bonds since the 2008 financial crisis. While Berkshire had 33% of its assets in bonds in early 2009, the conglomerate gradually decreased its allocation in fixed maturity securities during the past seven years. Currently, the allocation in bonds is 13%, which is near a 20-year low.
As discussed in a previous article, Buffett has increased his Phillips 66 (PSX, Financial) stake throughout the third quarter, including by more than 1 million shares Sept. 14. The downstream energy company’s stock price increased about $2 per share during September likely due to Buffett’s constant investments in the company.
Insiders more bearish on the market
As the price of the Standard & Poor’s 500 index exchange-traded fund steadily increases in 2016, insiders sell more of their company’s shares. As of Oct. 1, the insider buy-sell ratio is 0.23, which is near a six-year low. Additionally, the Oct.1 insider buy-sell ratio is about one-half that of the Sept. 1 ratio.
The CEO buy-sell ratio declined almost 60%, from 0.42% to 0.17% in September. This shows that top management is highly bearish on the market valuations for October.
Conclusions and see also
As the stock market is significantly overvalued, there is high “recession risk.” Due to the high risk of recession, Buffett and Charlie Munger (Trades, Portfolio) suggest staying defensive and look for companies that meet their four-criterion approach. Such companies have at least a four-star predictability rank, sustainable competitive advantage, high profit margins and growth rates, and little or no debt. Additionally, these companies are undervalued based on their PEPG, the P/E ratio divided by the average five-year EBITDA growth rate.
Based on backtesting results, investing in predictable companies generally leads to high overall returns compared to the benchmark. As discussed in the predictable rank article, the “Profitable Predictable Margin Expanders,” Undervalued-Predictable and Buffett-Munger investing strategies all outperformed the S&P 500 ETF during the backtesting period (2009-2016).
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Disclosure: The author has no position in the stocks mentioned in this article.
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