One of our favorite benchmarks for assessing the relative value of the US stock market is... Total Market Cap / GDP. *End of trading on April 26, 2013, the Total Market Index was valued at 16,698.8 billion. Total Market Capitalization is approximately 106% of GDP (including dividend returns of 2%).
Warren Buffett has pointed out that the percentage of total market cap relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.” [while GNP and GDP are different, the two numbers have historically been 1% of each other]
The Market has 5 zones of valuations: Ratio = Total Market Cap / GDP
1. Ratio < 50%: Significantly Undervalued
2. Ratio 50% - 75%: Undervalued
3. Ratio 75% - 90%: Fair Value
4. Ratio 90% - 115%: Overvalued
5. Ratio > 115%: Significantly Overvalued
**Where are we today (04/26/2013)? Ratio = 106% Overvalued (not far from Significantly Overvalued)
Based on these two numbers, one would have a mathematical expectation of achieving 2.8% return (per year) in an index fund.
Over the long-haul, stock market returns are governed by three main factors:
I. Interest rates
II. Corporate profitability
III. Market valuations
I. INTEREST RATES
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
II. CORPORATE PROFITABILITY
Corporate profitability has historically averaged 6%.
A. Corporate profit margins Shrink in BAD economic times.
B Corporate profit margins Grow in GOOD economic times.
*Similar to GNP and GDP, long-term economic growth and long-term corporate profitability tend to be about the same.
III. MARKET VALUATIONS
Peter Drucker used to explain how stocks and stock market valuations revert to its mean.
A. Buying indexes at HIGH valuations will demonstrate LOW long-term returns.
B. Buying indexes at LOW valuations will demonstrate HIGH long-term returns.
Source of influence: GuruFocus
