Building the perfect beast
Frequent readers and personal friends of mine know that I have a weakness for 80’s music. As I ponder the world of finance the US stock market reminds me of the title of my favorite album 29 years ago by Don Henley. Rather than point out the economic dislocations from current equity valuations, this post is a rather objective, math based approach to where we are.
My favorite measure of stock market valuation is the Total Market Capitalization over GDP. As stocks represent participation in the long term profits of companies within an economy, GDP represents the economic activity from which these profits come from. Therefore, the correlation between company profits and economic growth are closely tied in the long run. In the short run, euphoria tends to put rosy glasses on investors pushing equity prices above rational valuation whereas in economic downturns we find the opposite phenomena where investors turn extremely gloomy about the future punishing stock markets too severely.
According to 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.” I humbly agree. http://www.gurufocus.com/stock-market-valuations.php
Based on historical ratio of total market cap over GDP (currently at 109.1%), it(stock market) is likely to return 2.5% a year from this level of valuation over the next decade.
Total Market Cap over GDP First, let’s consider a market cap of 109% of GDP in historical context. Over 100 years, the average market cap/GDP ratio has been roughly 75%. Based on that historical average the market is about 30% over valued today. Interestingly, when total market cap crossed 100% in 1996, then Chairman Greenspan gave his “irrational exuberance” speech(below). Needless to say, the stock market is pricey no matter what the underlying economic fundamentals may be. However, keep in mind that the total stock market cap reached an astounding 180% of GDP in 2000 before all illusions of “the new economy” came to an end. While the stock market is objectively overvalued, emotion might send it higher in the short-term. In the long-term, reality is very likely to catch up with math and dash the euphoria that has taken hold once again.
“Guru Focus” expects “The US stock market is positioned for an average annualized return of 2.5%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 2%.” Total Market Cap over GDP As for the math behind the numbers please visit the website and explore. In my opinion, their formula for long-term market returns is rather accurate and thus, commonly followed by asset managers. Assuming that the stock market currently yields 2% in dividends we can expect the equities to be only about 5% higher ten years from today. If that is true, you might wonder if owning a 10 year Treasury at 2.2% might not make more sense after all. Now imagine if interest rates on the 10 year rise to 4% where would stocks have to be to compete with bonds at that point? 50% lower is a realistic estimate.
The big question is always when will the next bear market start? I don’t have the exact answer for you and if I did I probably would not share it freely. I will however point out a few signs of distress in the markets. First, take a look at record margin debt at the NYSE. Clearly, euphoria has taken over Wall Street once again.(This chart is a month old, the latest margin debt number beats the all time high from 2000).
The second canary in the coal mine is no other than Warren Buffet himself. In recent months, billionaire investors like Buffet, Soros and Paulson have been quietly selling shares. Why would they do so if all is well?http://www.moneynews.com/Outbrain/billionaires-dump-economist-stock/2012/08/29/id/450265?PROMO_CODE=FE8A-1
The third indicator of trouble in paradise can be found in the gold market. While the price of gold has come off it is notable that the actual metal is leaving the COMEX ware house at an alarming rate. It is quite counter intuitive to see investors take delivery of gold(in a falling market) if all were well in the financial world.
Building the perfect beast
As you can see, the stock market is reaching irrational highs yet again and while technical short-term indicators point to no imminent trend reversal it is apparent to me that the bigger this beast becomes the more ferocious it will be when it breaks free. And break free it will…
I close with an email excerpt from a friend and peer who summed up the current status quo in the financial markets in one quote:
“In the short-run, price dictates value….. But, in the long-run, value dictates price…”