- In the long run, corporate performance is defined by economic activity.
- The CAPE ratio is an excellent metric, but it has some limitations which we discuss.
- According to this metric, stocks have been more expensive only once: during the peak week of the dot-com bubble.
In the long run, there is no other way for stocks to go than to follow economic fundamentals.
Economic activity is what defines corporate growth and earnings. In the short term, this can be skewed by euphoria that pushes stocks into overvalued territory or by pessimism that creates unbelievable bargains (just remember 2009).
So how can you know when stocks are overvalued or undervalued? The most commonly used metric is the price to earnings ratio (P/E) ratio. However, the P/E ratio is very volatile and heavily under the influence of economic activity.
In January 2009, the P/E ratio was above 70 but stocks were cheap as the temporary low earnings were the direct result of the ongoing recession and financial crisis.
Figure 1: S&P 500 P/E ratio. Source: Multpl.
Given the high volatility of the P/E ratio, a metric that I prefer is the CAPE ratio (Cyclically Adjusted Price Earnings ratio) which uses 10 year average earnings to eliminate cyclical influences.
The figure below shows how the CAPE is much less volatile than the P/E ratio.
Figure 2: S&P 500 CAPE ratio. Source: Multpl.
Nevertheless, the CAPE ratio also has a few limitations.
The first limitation is that many stocks don’t have meaningful 10 year average earnings. Just think of Facebook (NASDAQ: FB), which wasn’t even traded until 2013.
The second limitation is that the length of a business cycle can be longer than 10 years, or even much shorter, so the CAPE can be skewed by two or three recessions in a decade. Thirdly, since 1990, according to Generally Accepted Accounting Principles (GAAP), companies need to account for their assets as market-to-market, but only if the market value is lower than the book value. This means that most long term earnings are skewed on the downside while the increases in asset values aren’t accounted for until the asset is sold.
So the CAPE is an excellent metric, but it has some limitations. Therefore, in today’s article, I’ll introduce you to Buffett’s favorite valuation metric, the market cap to GDP ratio.
The Market Cap To GDP Ratio
To quote Buffett:
“The ratio of market capitalization to gross national product (GNP) is probably the best single measure of where valuations stand at any given moment.”
The value of a stock market should reflect the value of the economy. If corporations start to earn too much money, there will be more competition or wages will increase and the profits should then be fairly shared among all market participants.
The stock market capitalization to GDP ratio measures the value of all listed shares in a stock market as a percentage of GDP. The higher the ratio, the more overvalued stocks are, and vice versa.
Figure 3: Stock market capitalization to GDP for the U.S. Source: FRED.
As you can see above, the metric has been pretty accurate in determining market peaks and bottoms. Stocks were cheap in the 1980s and most of the 1990s, around 2003 and 2009. These were all great periods for investing.
Conversely, stocks were expensive around 2000 and 2007, and are extremely expensive now. Currently, the stock market is even more expensive than it was at the peak of the dotcom bubble in 2000.
In the 10 years since the 2000 peak, investors have been faced with 12 years of negative returns as only in 2012 did the S&P 500 surpass its 2000 level.
Figure 4: It took the S&P 500 12 years to reach positive territory again. Source: Yahoo Finance.
Conclusion & What To Do
All of this sends a pretty straightforward message: long term returns are probably going to be negative or extremely low. This is because it’s already much more difficult for companies to find adequate employees, which means competition is going to intensify and earnings will barely grow over the next decade.
Secondly, the world is based on a relatively even distribution of wealth, at least in the long term. Knowing that many pension systems are badly funded, I wouldn’t be surprised if some governments go after the huge wealth created in stock markets in order cover for pension deficits. This would lower aggregate demand for stocks and consequently stock prices.
Thirdly, GDP is a very stable metric. Anything can happen in the short term, but the story is pretty clear in the long term: expect a reversion to the mean.
The “what to do” part is pretty simple. Assess whether what you own is overvalued because of corporate buybacks or temporarily low interest rates, and rebalance with assets that aren’t overvalued but will probably shine when the above ratios turn to the mean. Here are some interesting ideas: gold miners, emerging markets, air travel, concentrated portfolio, rebalancing and value investing.
Keep reading Investiv Daily as we’re always searching for ways to achieve double digit positive investing returns in the next decade, and avoiding the negative returns the S&P 500 offers.