Share Quotes: Market Valuations 03/27/2010

What returns can we expect from the stock market?
As of today, the Total Market Index is at $ 12133 billion, which is about 83.9% of the last reported GDP. The US stock market is positioned for an average annualized return of 3.4%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 0%.

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.”

Over the long term, the returns from stock market are determined by these factors:

1. Interest rate

Total Market Cap and US GDP

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett

2. Long Term Growth of Corporate Profitability

The Ratio of Total Market Cap to US GDP

Over long term, corporate profitability reverses to its long term trend, which is around 6%. During recessions, corporate profit margin shrinks, and during economic growth periods, corporate profit margin expands. However, Long term growth of corporate profitability is close to long term economic growth. The size of the US economy is measured by Gross National Product (GNP). Although GNP is different from GDP (gross domestic product), but the two numbers have always been within 1% in difference. Therefore, GDP is used here for calculation purposes. The US GDP since 1970 is shown in the top chart at the right.

3. Market Valuations

The Predicted and the Actual Stock Market Returns

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 03/27/2010, this ratio is 83.9%.

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 (03/27/2010)? Ratio = 83.9%, Fairly valued

The Sources of Investment Returns

The returns of investing in an individual stock or in the entire stock market are determined by these three factors:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.
What Returns Is the Market Likely to Deliver From This Level?
Putting all the three factors together, the return of an investment can be estimated by the following formula:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
The first two items of the equation are straightforward. The third item can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated from this:

(Re/Rb)(1/T)-1

The investment return is thus equal to:

Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1

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 03/27/2010, the stock market is likely to return 3.4% a year in the next 8 years.

Warren Buffett’s Market Calls

Based on these factors, Warren Buffett made a few market calls in the past. In Nov. 1999, when Dow was at 11,000, a few months before the burst of dotcom bubble, stock market had gained 13% a year from 1981-1998. Warren Buffett said in a speech to friends and business leaders, “I’d like to argue that we can’t come even remotely close to that 12.9… If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

Two years after the Nov. 1999 article, when Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

Nine years have passed since the publication of the article of November 22, 1999, it has been a wide and painful ride for most investors; Dow went as high as 14,000 in October 2007 and retreated painfully back to 8,000 today. Again, Warren Buffett wrote in Oct. 2008: Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”

Article Source from www.gurufocus.com

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