Thursday, January 07, 2016

2016? Don't get your hopes up

The most important indicator of the stock market valuation is what we called Buffett-indicator. It is the ratio of total market cap over GNP. 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.”

As of today, the ratio is standing at 114.3%. If we assume the ratio will revert to the mean in 8 years, the market will average exactly 1% of return over the next 8 years, including dividends.

This seems very pessimistic. But the ratio has been quite accurate in predicting long term market returns.

Shiller P/E Ratio and Its Predictions

Shiller P/E, named after its invention Prof. Robert Shiller of Yale University, is another more objective measurement of the market valuation. As of today, it sits at 25.3, which is about 51.5% higher than the historical mean of 16.7.

Shiller P/E certainly indicates that the market is wildly overvalued. Historically only three periods the ratio was higher, the bubble of 1929, the tech bubble of 1999 and the financial bubble of 2007. The regular P/E is 21, which is also much higher the historical mean of 15.9.

We can use the similar revert to the mean methodology to calculate potential market returns. At today’s Shiller P/E, the market is likely to return 0.3% a year over the next 8 years, which is similar to the conclusion we reached from the Buffett indicator.

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