market valuation

What a great year it was! The market was up 30%, the best year since the go-go years of 1990s.The good news is that our account balance is higher, investors are more bullish. The bad news is that we will see lower future returns.

So where are we with the market valuation and the expected return starting 2014?

The ratio of Total Market Cap over GNP, Warren Buffett’s “the best single measure of where valuations stand at any given moment,” is standing at 115%. This ratio is already higher than the pre financial crisis peak of 107% and is higher than any time except for the go-go years of late 1990s, when it reached 141%. Its historical mean is around 85%.

Shiller P/E, the cycle adjusted P/E ratio, is now at 25.6, 55.2% higher than the historical mean of 16.5.

If we assume that the ratio of total market cap over GNP (Buffett’s indicator) and Shiller P/E will reverse to their mean over time, which they always did in the past, the future market returns do not look good. Using 8 years as time the market will reverse to its mean, both Buffett’s indicator and Shiller P/E suggest that the stock market will average 1% a year (2% dividends contribution included) over the next 8 years. At 1% of total market return, the market indices will be lower than they are now after 8 years.


Howard Marks, one of the smartest investors from Oaktree Capital, describes the three stages of a bull market:

· the first, when a few forward-looking people begin to believe things will get better
· the second, when most investors realize improvement is actually underway, and
· the third, when everyone’s sure things will get better forever

He also wrote the three stages of a bear market:

· the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
· the second, when most investors recognize things are deteriorating, and
· the third, when everyone’s convinced things can only get worse

In May 2012, he thought we were at the first stages of bull market: a few forward-looking people begin to believe things will get better. In May 2013, he thought that we were somewhere in the first part of stage two.

After a gain of 30% in 2013, investors are more bullish. We don’t know which stage of bull market Howard Marks thinks we are now, but we believe that we are either at late second stage or early third stage.