Friday, September 21, 2012

US Stocks Now Above 100% of GDP

It is a great market, isn’t it? From the beginning of the year, the S&P 500 has gained 16.4%, fueled by central banks’ quantitative easing actions around the world. We thought that the stock market was overvalued already at the beginning of the year…

If the central banks’ goal is to elevate the stock prices, they have done it successfully. But if their goal is to stimulate the economy, we are not sure if they have achieved their goal. But one thing is for sure, a higher current valuation of any asset classes always increases the risks of investing in them. A higher gain in the past means a lower gain in the future.

Now for the third time since 1970 (that is when our data become available), the total market cap index is more than 100% of the GDP. The other two times were in the late 1990s to 2000 and 2006 to 2007. Both ended badly, unfortunately.

Please see the chart below, which is from our total market valuation page:

Some investors may have forgotten; others were probably too young to experience the pain. The late 1990s to 2000 stock market was after a decade of bull market and fueled by the unprecedented tech bubble. The total market index was pushed to about 150% of GDP. But the burst of the tech bubble brought the S&P 500 from around 1530 in March 2000 to 800 in October 2002, a loss of 48%. The tech-heavy NASDAQ lost almost 80%. Today, 12 years later, even after strong recoveries, it is still about 40% lower than its peak in 2000.

The 2006 to 2007 high valuation was a byproduct of the housing bubble. The total market index was above 110% of the GDP, which is much lower than its 2000 peak, but it ended even worse. The S&P 500 lost more than 56% from its peak in October 2007 to its trough in March 2009. The economic impact was much broader and it lasted much longer.

The quantitative easing programs started in 2009 definitely eased investors’ fear and pushed them back into stocks. What else could they do? In 2007 an investor could buy government bonds which yielded around 6%, or he could buy a CD with a 5% interest rate. But what can he do today? He was told that stock dividend yield is now higher than government bond yield, so stock is a better investment. Now the total market index is more than 100% of the GDP, again, the third time.

How will this one end?

At its current market valuation, though lower than it was in 2007, the implied return is actually lower than it was in 2007 because of the declined growth rate of the economy. An alternative approach, Shiller P/E, is predicting an even lower return. Please see the chart below:

The chance for the stock market to do well from this point on requires the market valuation to go even higher and stay high for long enough so that the economy can catch up. Will this happen? Well, nothing is impossible.

What should you do? The answer is it depends. If you are investing other people’s money and your goal is to beat the market average, you should invest in high-quality companies that are traded at reasonable prices, like the ones we have for our Buffett portfolio, which has gained 19% this year and beat the market index every year since inception. If you are investing your own money, you are more likely concerned about absolute returns. You don’t want to be in a situation when the market lost 40% and you “just” lost 35%. If that is the case, you may have to be patient, willing to sacrifice short-term gains and focus more on risks and long-term returns.

Either way, don’t expect too much for the stock market from this point on.

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