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Where Are We with Market Valuations? Where to Find Bargains? – Oct. 2009 Update

October 28, 2009

We have written articles about the general market valuations when Dow was at 9,000, and 8,000. Using Warren Buffett’s stock market matrix, we also developed a page calculating the expected return from the market for the coming years. Now Dow is hovering around 10,000. We would like review again where we are with market valuations, and what we can expect from the market over the next decade.

When Dow was around 8,000 back in February, we concluded that investors could expect more than 10% a year for the coming years and “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree,” as Warren Buffett wrote in Oct. 2008 in his op-ed on New York Times. The conclusion was quickly confirmed by the market, which shot up more than 50% from its March lows.

Where Are We with Market Valuations?

As corporate America reports better earnings, investors and consumers alike become more optimistic, risk taking is again encourage, the stock market landscape has changed… for the worse. If the market was undervalued back in Feb., it is fair valued now, at the best. As of today, the Total Market Index (Wilshare 5000) is at $ 10927.6 billion, which is about 77.2% of the last reported GDP. The US stock market is positioned for an average annualized return of 6.2%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 2.18%. For details, go to Where Are We with Market Valuations?

Please note that this prediction is by no means exact, although it has a pretty good track record. The future return is dependent on the future economic growth and interest and future market valuations. As we all know, stock market is never rational, most of times it is either overvalued or undervalued. Over the past 20 years, it has been mostly over valued. In any case, the actual market return will likely be within the bands of green and red in the chart below, currently reading -2.1% and 11.4%, respectively.

To further explain, we like to use some historical analogies. If in the coming years the US economy is back to what it was like in 1970’s, interest rate rising, inflation at double digits, we will likely to have a negative 2% return a year from this point. If interest rates stays low, US economy grows healthily, AND the stock market returns to its unprecedented bubble of 1999, we can expect 11% annually from this point.

If nothing likes those happens, we will probably have mid single digit returns from the market.

Jeremy Grantham of GMO, the best investment strategist of our time, thinks that the fair value of the S&P500 is 860, therefore the market is currently 25% over valued. In his shareholder letter released yesterday he wrote that he expects the market to return 2% a year, which is lower than, but reasonably close to our predications. Mr. Grantham predicted the financial bubble and low returns back in 2007. In the brief “a few minutes” of March 9th, the market was undervalued to him, and he wrote a letter titled “Reinvest When Terrified” to shareholders. Who said you cannot time the market?

John Hussman, who wrote weekly market commentary, thinks the market is over valued, too. Mr. Hussman successfully pointed out the market peak back in Oct. 2007, and hedged his investment in 2008 and avoided big loss. He uses peak P/E to calculate market valuation and expected returns. His conclusion is very close to ours.

Where to Invest Now?

With a fair-valued or moderately over-valued market, where to invest now? Mr. Grantham wrote:

“We can find a sufficient group of equities at or very close to fair value. U.S. high quality, foreign developed (EAFE), and some emerging (with the benefit of the doubt) are collectively a reasonable buy.”

“We like owning high-quality blue chips if we are indeed going into a more difficult seven years than any we have faced since the 1970s.”

“And for nervous investors there is yet another reason for favoring quality stocks: their more than 50% foreign earnings component, which is higher than the balance of the S&P 500 with its heavy financial component. In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest.”

Mr. Grantham expects that high quality companies to have a 7% lead over S&P500 for the coming years. This agrees with the conclusions we drew from our back-test of the market from 1998 to 2009 (See GuruFocus Research Report: What worked in stock market? Business Predictability and Predictability Rank)

What are High Quality Companies and Where to Find Them?

To Mr. Grantham, high quality companies are the ones with high, stable return and low debt, which coincides with what Warren Buffett definition of “good companies”, that is the companies with predictable and proven earnings, and little debt.

GuruFocus is dedicated in investing in good companies. We have developed the concept of Business Predictability Rank, which rates the long term consistency of business, and you can find at each company’s quote pages. Out of more than 10,000 stocks covered, less than 100 of them are top ranked. Please check out the list of top-ranked predictable companies (Premium Members only).

Among the predictable companies, we have also filtered them using Buffett-Munger investment criteria to find companies with these qualities:

  1. Companies that have high Predictability Rank, that is, companies that can consistently grow its revenue and earnings.
  2. Companies that have competitive advantages. It can maintain or even expand its profit margin while growing its business
  3. Companies that incur little debt while growing business
  4. Companies that are fair valued or under-valued.
These companies are collected under Buffett-Munger Screener - Good Companies at Fair or Undervalued Prices. We also publish a monthly newsletter which provides deep analysis of the investment returns and risks with these companies. If you are not a Premium Member, we invite you to sign up for the 7-day Free Trial.

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