Monday, February 12, 2018

How Fairly Valued is the Stock Market?

Updated February 22, 2018

One measure of equity valuation, informally known as the Buffett Ratio, is reputedly Warren Buffett's preferred measure of stock market valuation.  With the volatility in the stock market in recent days in mind, let's take a historical look at this measure of stock value which is measured as:

"the ratio of a nation's stock market capitalization to the overall gross national product of the economy".

Let's start with this graph from FRED which shows the total stock market value of all non-financial American companies, current to the third quarter of 2017, well before the market rose sharply in late 2017 and early 2018:

At $25.784 trillion, the market has risen by 201.1 percent from its Great Recession low of $8.564 trillion.

Here is a graph from FRED showing the Gross National Product since 1947:

At $19.729 trillion in the third quarter of 2017, the nation's GNP has risen by 36.4 from its Great Recession low of $14.465 trillion.  When you compare the growth in the gross national product to the growth of the value of Corporate America's equity, you can see how stock market valuations have far outstripped the growth in the economy as shown here:

Now, let's use both graphs to give us the ratio of the total market value of Corporate America to gross national product also known as the Buffett Ratio:

As you can see, the Buffett Ratio is just below the all-time high that it reached during the tech bubble at the beginning of the new millennium. 

It is generally considered that, if the stock market valuation is below 50 percent of the GNP, it is too low.  Between 75 percent and 90 percent, valuations are fair.  If it is above 115 percent, the market is overvalued on a relative basis.  Using the Fed's data, in late 2017, the market was over 130 percent of GDP.  Over the seven decades years from 1947 to 2017, the arithmetic mean Buffett Ratio was 67.59 and the median value was 63.99.  Values ranged from a low of 34.91 in 1982 to a high of 135.33 in 2000...and we all know how that movie ended, don't we?  The latest Buffett Ratio as calculated using the Federal Reserve data of 119.06 is 76.2 percent above the long term arithmetic mean and 86.1 percent above the long-term median.  Since the Federal Reserve Bank of St. Louis does not provide up-to-date total equity prices, let's look at an analysis by Jill Mislinski at Advisor Perspectives which is current to February 2018.  Her analysis using the Federal Reserve "Nonfinancial Corporate Business; corporate equities; liability, level" data (as I have used) shows the following:

Peak Corporate Equities to GDP: 151.3 percent (2000)

Great Recession Low Corporate Equities to GDP: 59.5 percent (2008)

Current Corporate Equities to GDP: 138.6 percent

When using the broader Wilshire 5000 Index to GDP data, she finds the following:

Peak Corporate Equities to GDP: 137 percent (2018)

Great Recession Low Corporate Equities to GDP 56.8 percent (2008)

By way of comparison, using the Wilshire 5000 Index, the previous peak of 136.5 percent was hit during the tech boom in 2000, a peak that the market has now surpassed.

A 2015 paper by Ted Berg at the Office of Financial Research (OFS) on the overvalued stock market concludes by noting that systemic crises are proceeded by bubbles and that four factors accelerate the emergence of asset bubbles:

1.) expansive monetary policies.
2.) lending booms.
3.) foreign capital inflows.
4.) financial deregulation.

Given that Corporate America has done this since the Great Recession:

...and that consumers have done this:

...I think that it's pretty safe to assume that, should the Fed continue to tighten and consumers, who are responsible for 70 percent of America's economy, cut back on their expenditures, we could see a continuation of the stock market readjustment over the longer term.  As well, it is largely the dumping of trillions of dollars into the economy by the Federal Reserve since 2008 that has "floated the stock market's boat".  All of that "cash" has to go somewhere.

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