We’ve started a new investment feature designed to give you some background on current market trends. Our first piece poses a very important question about the health of the stock market:
Rushing in when others are rushing out: that describes not only firefighters, but a certain type of contrarian investor.
Perhaps the most notable is Warren Buffett, who preaches being fearful when others are greedy and being greedy when others are fearful.
Now place that strategy against the backdrop of the last five years, when the market rebounded strongly in the wake of the global financial crisis. In 2013 alone, the S & P 500 soared by 29.6 percent and the Dow Jones Industrials went up by a robust 26.5 percent.
Those gaudy numbers are prompting some people who had sworn off the markets for good to re-consider their positions. Wherever you may reside on the spectrum, from enthusiastic market investor to lifetime spectator, one fundamental truth to keep in mind is that professional investors look at various valuation metrics when deciding the timing of their investments.
Among the most well-known:
- The trailing Price/Earnings ratio
- The Price/Book Value ratio
- The dividend yield of the market
- The Schiller Price/Earnings ratio
- The PEG ratio (the Price/Earnings to Growth ratio)
But a lesser-known metric is one that Warren Buffett has termed his favorite measure of stock market valuation: the ratio of the total market capitalization of the US stock markets to the total dollar value of the GDP (total US stock market capitalization/GDP).
Buffett characterizes it as “probably the single best measure of where valuations stand at any given moment.”
As he stated in a 2001 Fortune story, Buffett believes that whenever the market valuation/GDP ratio is 100 percent or greater, then it is time to be cautious on stock investing. Using the Dow Jones US Total Market Index and the last reported dollar value of the GDP, the Buffett Market valuation/GDP index is about 115.8 percent as of Friday, May 9th.
This index doesn’t mean that you have to sell stocks when the reading goes above 100 percent, but it reflects heightened risk in the equity markets. A great buying point for stocks occurred in March 2009, when this ratio declined to about 60 percent (and Buffett invested heavily, and most profitably, in General Electric and Goldman Sachs).
By comparison, the ratio was 183 percent during the tech bubble of 2000 and 135 percent in 2007, just before the housing and financial crash.
Most stock market peaks have occurred when this ratio is well above 100 percent but it would be wrong to suggest that U.S. stocks could not go higher. As Buffett has warned, “The ratio has certain limitations in telling you what you need to know.”
Professional investors generally don’t use a single indicator to make buy/sell decisions. But they do use multiple indicators to decide when to move money between asset classes. With the stock market capitalization/GDP ratio over 115 percent most professionals would begin to lower their U.S. stock market allocations if they found further confirmation in other indicators.
DISCLAIMER: The information contained in this article is not a solicitation to sell securities or investment advisory services where such an offer would not be legal. Information included in this statement regarding market or other financial information is obtained from sources believed to be reliable. Past performance is never a guarantee of future performance.
John Maguire has been an Investment Advisor for more than 30 years. He is a Managing Partner of Hinsdale-based Rationalis Capital Management, LLC, online at www.rationaliscapital.com. He can be reached at firstname.lastname@example.org.