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Market Valuation Page Released: The stock market is Modestly Undervalued, it is likely to return 11% a year

April 13, 2009

The stock market is Modestly Undervalued, it is likely to return 11% a year in the next 8 years. GuruFocus has developed a stock market valuation tool which shows the daily market valuations. The market valuation is assigned as Over-Valued, Fair-Valued or Under-Valued. The market valuation is based on the ratio of the total US market cap relative to the US economy.

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.” The chart on the right shows what would happen if GDP is used instead of GNP.

Total Market Cap and US GDP

The Ratio of Total Market Cap to US GDP

The Predicted and the Actual Stock Market Returns

Market Valuations

In the long run, stock market valuation reverses to its mean. A higher current valuation certainly results in lower long term returns in the future. On the other hand, a lower current valuation level results in a higher future long term return. The total market valuation is measured by the ratio of total market cap (TMC) over GNP, this is Warren Buffett's "best single measure". This ratio since 1970 is shown in the middle chart at the right. This ratio is updated daily. As of 04/11/2009 , this ratio is 61.6%.

We can see that during the past four decades the TMC/GNP ratio has varied wildly. The lowest point was about 35% in the previous deep recession of 1982, while the highest point was 148% during the tech bubble in 2000. The market went from extremely undervalued in 1982 to extremely overvalued in 2000.

Based on these historical valuations, we have divided the market valuation into five zones:

Ratio = Total Market Cap / GDP Valuatoin
Ratio < 50%Significantly Undervalued
50% < Ratio < 75% Modestly Undervalued
75% < Ratio < 90% Fair Valued
90% < Ratio < 115% Modestly Overvalued
Ratio > 115% Significantly Overvalued
Where are we today (4/11/2009)? Ratio = 61.8%, Modestly Undervalued

As discussed previously, the returns of investing in an individual stock or in the entire stock market are determined by these three factors: 1. Business growth, 2. Dividends, and 3. the Change in the market valuation, that is:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

This equation is actually very close to what Dr. John Hussman uses to calculate market valuations. From this equation we can likely return of the stock market. In the calculation, the time period we used was 8 years, which is about a full economic cycle. The calculated results are shown in in the bottom chart at the right. The green line is the expected return if the market becomes undervalued (TMC/GNP=40%) in 8 years from current levels, the red line is if the market becomes overvalued (TMC/GNP=120%) in 8 years. The brown line is if the market becomes fair-valued (TMC/GNP=80%) in 8 years.

The thick bright line in the bottom right chart is the actual annualized return of the stock market in 8 years. We can see the calculations largely predicted the trend in the returns of the stock market. The swing of the market returns is related to the change of the interest rate.

It has been unforunate for investors who entered the market after the late 1990s. The market has been always overvalued, only until the recent decline since 2008. From Oct. 2008, for the first time in 15 years, the market is positioned for meaningful positive returns.

As of 04/11/2009 , the stock market is likely to return 11% a year in the next 8 years.

The market valuation is updated daily at The Page of the Stock Market Valuations

Rating: 2.9/5 (45 votes)


Gurufocus premium member - 11 years ago
This is a very good point. We will try to put interest rate factor in.

There will be two variables, one is future market valuation, the other is interest rate.
The Belgian
The Belgian - 11 years ago    Report SPAM
1) Would it be possible to have an extended graph which covers also the Great Depression period ?

2) Would it be possible to mention the source of the W. Buffett quotation ?

3) Could you please let us know if any adjustement has been made in order to take into account of the following three potential biais (in addition to the inflation biais pointed out in a previous comment):

(i) the increase or decrease over time of the average level of companies debt (since you use Total Market Cap instead of Total Entreprise Value, which would includes debt);

(ii) the increase or decrease over time of the average portion of foreign operations of US companies compared to their total operations (since you compare to the US GDP, the Total Market Cap, which cover all the operations of the US companies, including their operations outside US);

(iii) the increase or decrease over time of the portion that listed companies have in the US economy, compared to non listed companies (since Total Market Cap excludes non listed companies)?

Kirk Spano
Kirk Spano - 11 years ago    Report SPAM
Intetest rates while important, don't change the big picture much as far as valuation, hence why the lines track so well over time. Interest rates can somewhat predict inflection points in the short run. Please don't fetter up the TMC/GDP graph with short term indicators that may or may not matter. Perhaps a secondary chart more in tuned with trading reversals. Good job on this, makes getting the data easier.
Anand - 11 years ago    Report SPAM
The market is seriously undervalued in many commodity sectors, for example, natural gas. One 1000 cubic feet of n.gas is selling at $3.60 and the same amount of soil will cost about $10 in most urban areas. The same undervalue applies to many commodities. But the market is only "slightly" undervalued because USA is an "advanced Hi-tech" society. It has "great" engineering. My god! Most Physicists (I am one) and Chemists can't find jobs - the University graduate departments would close without Indians & Chinese, including Berkeley's. How long can you maintain your GDP with this dollar advantage?
Freddyv - 11 years ago    Report SPAM
And why would they only go back to 1970? In fact if you go back through the entire history of the stock markt you see that the stock market is still slightly above "fair value" and is likely to drop well below as we compensate for the tremendous overvaluations we saw in the past 2-3 decades.

History clearly shows that the market moves in long cycles that see valuations go from over-priced, like in the 90's and 00's to under-priced, like in the 70's or 30's and 40's. Considering that we have yet to see a single year with a P/E of less than 15 (the historic AVERAGE) in some 2 decades suggests that the next 10 years or so will not be pretty for stocks.
Callaquin - 11 years ago    Report SPAM
11% yearly return... lol.
Callaquin - 11 years ago    Report SPAM
I don't think the average company in the U.S is worth 15 times earnings. There are, however, a few select opportunities.
Rgarga - 11 years ago    Report SPAM
Does anybody have access to what this tmc/gnp ratio has been in decades past... the analysis from prem watsa suggests that average has been 60%, which suggests that market is now fairly valued and not undervalued and perhaps that is why he only has 22% stocks.
Callaquin - 11 years ago    Report SPAM
The thing is that today there are way more (as percentage of population) investors and value investors than in the past, so the past levels should be lower.
Max7777 premium member - 11 years ago
The average Mkt Cap/GDP ratio has been 59.5% if you look over the last century, so today's ratio at first glance is not pointing at a truly undervalued market. this ratio was below today's level for almost 2 decade between 1973 to 1993 and it also was below 60% from 1937 to 1960 for more than 20 years again. But after much research i have come to the conclusion that the ratio we are now looking at is not correct and therefore gives us the wrong conclusions.

To look at something like GDP over a 100 year span or even at market cap, you truly need to adjust for inflation and look at real numbers. If you adjust for inflation the data changes hugely. And if you want to look at averages over many decades you need to adjust to the same inflation formula. So you need to adjust to the old CPI formula (pre 1982 adjustment). Once you do that we are now no longer at a 60% Ratio but at a much more attractive and lower ratio, around 50%.Typically, a ratio value of around 50% shows true undervaluation.
Sivaram - 11 years ago    Report SPAM
Buffett was actually looking at GNP but I think GDP is also good enough (all these are just rough benchmarks)...

Max7777: "To look at something like GDP over a 100 year span or even at market cap, you truly need to adjust for inflation and look at real numbers."

I'm not sure that is required. The market cap is also nominal so I don't think you need to discount GDP by inflation.

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