Friday, February 20, 2009

Where Are We with Market Valuations? What Can We Expect for the Next Decade? – Feb. 2009 Update


In October 2008, we wrote an article on the market valuations and what returns we could expect from the stock market over long term. Dow was around 9000. Today we are officially in recession, GDP has seen its largest drop in 3 decades, Dow is at 8000. What can we expect from the stock market from this point on?

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.”(insert source) Over long term, the returns from stock market are determined by these factors:

1. Interest rate

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett

2. Long Term Growth of Corporate Profitability

Although we are now in a recession, we are seeing a steep decline of corporate profitability. However, corporate profitability should reverse to its long term trend as economy stabilizes, which is around 6%. Long term growth of corporate profitability is close to long term economic growth.

3. Current Market Valuations

In the long run, stock market valuation reverses to its mean. A higher current valuation certainly results in lower long term returns in the future. On the other hand, a lower current valuation level results in a higher future long term return,

Warren Buffett’s Market Calls

Based on these factors, Warren Buffett made a few market calls in the past. In Nov. 1999, when Dow was at 11,000, a few months before the burst of dotcom bubble, stock market had gained 13% a year from 1981-1998. Warren Buffett said in a speech to friends and business leaders, “I'd like to argue that we can't come even remotely close to that 12.9... If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

Two years after the Nov. 1999 article, when Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

Nine years have passed since the publication of the article of November 22, 1999, it has been a wide and painful ride for most investors; Dow went as high as 14,000 in October 2007 and retreated painfully back to 8,000 today. Again, Warren Buffett wrote in Oct. 2008: Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”

The Sources of Investment Returns

The returns of investing in an individual stock or in the entire stock market are determined by these three factors:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

Our backtesting has clearly showed that for individual businesses, everything else equal, lower valuations lead to higher returns.

Putting all the three factors together, the return of an investment can be estimated by the following formula:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

The first two items of the equation are straightforward. The third item can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated from this:


The investment return is thus equal to:

Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1

This equation is actually very close to what Dr. John Hussman uses to calculate market valuations (insert source). In the past decade, he has been saying that the market has never been reasonably undervalued, and for that, he was called a “Perma Bear”.

As we discussed, the ratios here can be any commonly used ratios. However, if we use the most common ratio such as P/E, it can be misleading. This is because P/E ratio strongly depends on profit margin, which may fluctuate dramatically at different point of business cycles. To eliminate this factor, John Hussman uses Price to Peak Earnings as P/E ratio. Here we like to the ratio Warren Buffett uses, i.e. the ratio of Total Market Cap to GNP.

So what can we expect from the stock market?

From the equations we can estimate what returns we may get from the market. Currently we have an average stock dividend yield of about 3.5%. The US economy grows at about 4.7% over the past 10 years. With the Dow at 8000, we have a ratio of total market cap to GNP of about 60% (See chart below). We use the time period of 8 years to calculate the contribution of the change in market valuations, we get an estimated annualized return as the function of future valuations.


Dividend Yield


GNP Growth


Current TMC/GNP


Years of Market Cycle


Estimated Annualized Return:

Future TMC/GNP Ratio

Contribution from Change of Valuation

Investment Return








































As we can see that the future investment returns largely depend on the change of the market valuation, the overall, the chance of losing money from this point on is small if TMC/GNP stays in the range of where it has been in the past three decades, which is between 40% and 150%. Therefore being a long term investor in the current market is of reasonably low risk. If 8 years later the market valuation is the same as the current, we may expect about 8% a year, which is contributed by both the economic growth and the dividends. If the market ratio returns to the median level over the past 3 decades, we may expect more than 11% a year. If the market goes wild again, like it did in 1999, the return can be an enormous 20% a year, which is great… unless you sell out completely at that point.

Where will the market be in 8 years? GuruFocus does not want to make a prediction. But with this study we are more convinced of what Warren Buffett said in Oct. 2008: “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.