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Posts Tagged ‘Warren Buffett’

Here’s the updated St Louis Fed’s FRED on Warren Buffett’s favored market measure, total market capitalization-to-GNP:

FRED Graph

The Q1 2013 ratio – the most recent point – is 110 percent.

According to the FRED data, the Q1 2000 TTM/GNP peak ratio was 158 percent, and the Q3 2007 TTM/GNP peak was 114 percent. The average for the full period – Q3 1949 to Q3 2012 – is 69 percent. The last time the market traded at a below-average ratio was Q1 2009.

Here’s the log version:

FRED Graph

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Warren Buffett’s favored market valuation metric, market capitalization-to-gross national product, has passed an unwelcome milestone: the 2007 valuation peak, according to GuruFocus:

TMTGNP 2007

The index topped out at 110.7 percent in 2007, and presently stands at 111.7 percent. From GuruFocus:

As of today, the Total Market Index is at $ 17624.4 billion, which is about 111.7% of the last reported GDP. The US stock market is positioned for an average annualized return of 2.2%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 2%.

I’ve seen several arguments for why this time is different, and why it’s not a bubble. I don’t buy it. When we see clear skies, that’s all we can imagine, and so we extrapolate it over the horizon. From Seth Klarman’s latest:

Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals–recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the U.S.– is the riskiest environment of all.

[O]nly a small number of investors maintain the fortitude and client confidence to pursue long-term investment success even at the price of short-term underperformance. Most investors feel the hefty weight of short-term performance expectations, forcing them to take up marginal or highly speculative investments that we shun. When markets are rising, such investments may perform well, which means that our unwavering patience and discipline sometimes impairs our results and makes us appear overly cautious. The payoff from a risk-averse, long-term orientation is–just that–long term. It is measurable only over the span of many years, over one or more market cycles.

Our willingness to invest amidst failing markets is the best way we know to build positions at great prices, but this strategy, too, can cause short-term underperformance. Buying as prices are falling can look stupid until sellers are exhausted and buyers who held back cannot effectively deploy capital except at much higher prices. Our resolve in holding cash balances–sometimes very large ones–absent compelling opportunity is another potential performance drag.

For more on market value-to-GNP see my earlier posts Warren Buffett Talks… Total Market Value-To-Gross National ProductWarren Buffett and John Hussman On The Stock MarketFRED on Buffett’s favored market measure: Total Market Value-to-GNPThe Physics Of Investing In Expensive Markets: How to Apply Simple Statistical Models.

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Chris Turner has a guest post at Doug Short’s Advisor Perspectives called When Warren Buffett Talks … People Listen examining Warren Buffett’s favored market valuation metric: Market Value divided by Gross National Product. (I’ve also examined market value-to-GNP several times. See Warren Buffett and John Hussman On The Stock MarketFRED on Buffett’s favored market measure: Total Market Value-to-GNPThe Physics Of Investing In Expensive Markets: How to Apply Simple Statistical Models)

Here Chris looks at the metric using the CPI deflator on both the numerator — market value — and the denominator — Gross National Product.

Here Chris calculates two fair values for the S&P 500. The blue line shows the historical mean and the green line shows Buffett’s 80 percent value estimate:

Chris comments:

Readers can see from the chart that based on both Buffett’s rule and the historical mean, the S&P would be trading much lower from present levels. The S&P would be sub 1000 based on the historical mean and around 1150 based on the 80% Buffett rule.

Read When Warren Buffett Talks … People Listen.

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Ratio of Corporate Profits-to-GDP and Returns (1947 to Present)

Source: Hussman Weekly Comment “Taking Distortion at Face Value,” (April 8, 2013)

Warren Buffett, 1999

[F]rom 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.

– Warren Buffett, Mr. Buffett on the Stock Market (November 1999)

Jeremy Grantham, 2006

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

– Jeremy Grantham, Barron’s (c. 2006), via Katsenelson, The Little Book of Sideways Markets.

John Hussman, 2013

In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise.

– John Hussman, Two Myths and a Legend (March 11, 2013)

h/t Butler|Philbrick|Gordillo and Associates

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Butler|Philbrick|Gordillo and Associates’ argue in Valuation Based Equity Market Forecasts – Q1 2013 Update that “there is substantial value in applying simple statistical models to discover average estimates of what the future may hold over meaningful investment horizons (10+ years), while acknowledging the wide range of possibilities that exist around these averages.”

Butler|Philbrick|Gordillo use linear regression to examine several variations of the Shiller PE (and other cyclically adjusted PE ratios over periods ranging from one to 30 years), Tobin’s q ratio and Buffett’s total market capitalization-to-gross national product ratio (“TMC/GNP”). They have analyzed the power of each measure to explain inflation-adjusted stock returns including reinvested dividends over subsequent multi-year periods, setting their findings out in the following matrix:

Matrix 1. Explanatory power of valuation/future returns relationships

Source: Shiller (2013), DShort.com (2013), Chris Turner (2013), World Exchange Forum (2013), Federal Reserve (2013), Butler|Philbrick|Gordillo & Associates (2013).
Butler|Philbrick|Gordillo comment:
Matrix 1. contains a few important observations. Notably, over periods of 10-20 years, the Q ratio, very long-term smoothed PE ratios, and market capitalization / GNP ratios are equally explanatory, with R-Squared ratios around 55%.  The best estimate (perhaps tautologically given the derivation) is derived from the price residuals, which simply quantify how extended prices are above or below their long-term trend.The worst estimates are those derived from trailing 12-month PE ratios (PE1 in Matrix 1 above). Many analysts quote ‘Trailing 12-Months’ or TTM PE ratios for the market as a tool to assess whether markets are cheap or expensive. If you hear an analyst quoting the market’s PE ratio, odds are they are referring to this TTM number. Our analysis slightly modifies this measure by averaging the PE over the prior 12 months rather than using trailing cumulative earnings through the current month, but this change does not substantially alter the results.As it turns out, TTM (or PE1) Price/Earnings ratios offer the least information about subsequent returns relative to all of the other metrics in our sample. As a result, investors should be extremely skeptical of conclusions about market return prospects presented by analysts who justify their forecasts based on trailing 12-month ratios.

Butler|Philbrick|Gordillo note:

Our analysis provides compelling evidence that future returns will be lower when starting valuations are high, and that returns will be higher in periods where starting valuations are low.

So where are we now? Table 1 below from the post provides a snapshot of some of the results from Butler|Philbrick|Gordillo’s analysis. The table shows estimated future returns based on an aggregation of several factor models over some important investment horizons:

Table 1. Factor Based Return Forecasts Over Important Investment Horizons

Source: Shiller (2013), DShort.com (2013), Chris Turner (2013), World Exchange Forum (2013), Federal Reserve (2013), Butler|Philbrick|Gordillo & Associates (2013)

Butler|Philbrick|Gordillo note that:
You can see from the table that, according to a model that incorporates valuation estimates from 4 distinct domains, and which explains over 80% of historical returns since 1871, stocks are likely to deliver 1% or less in real total returns over the next 5 to 20 years. Yikes.

They conclude:

[T]he physics of investing in expensive markets is that, at some point in the future, perhaps years from now, the market has a very high probability of trading back below current prices; perhaps far below.

The post is a well-researched, and comprehensive analysis of several long-term market-level valuation measures. It is a worthy contribution to the research in this area. Read Valuation Based Equity Market Forecasts – Q1 2013 Update.

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In The Equity Q Ratio: How Overvaluation Leads To Low Returns and Extreme Losses I examined Universa Chief Investment Officer Mark Spitznagel’s June 2011 working paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes (.pdf), and the May 2012 update The Austrians and the Swan: Birds of a Different Feather (.pdf), which discuss the “clear and rigorous evidence of a direct relationshipbetween overvaluation measured by the equity q ratio and “subsequent extreme losses in the stock market.”

Spitznagel argues that at valuations where the equity q ratio exceeds 0.9, the 110-year relationship points to an “expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P500 within the next few years; these probabilities continually reset as valuations remain elevated, making an eventual deep drawdown from current levels highly likely.”

In his 2011 and 2012 papers, Spitznagel describes the equity q ratio as the “most robust aggregate overvaluation metric, which isolates the key drivers of valuation.” It is also useful in identifying “susceptibility to shifts from any extreme consensus,” which is important because “such shifts of extreme consensus are naturally among the predominant mechanics of stock market crashes.”

He observes that the aggregate US stock market has suffered very few sizeable annual losses (which Spitznagel defines as “20% or more”). Extreme stock market losses are by definition “tail events” as Figure 1 demonstrates.

Figure 1 shows how infrequently large drawdowns occur. However, when the equity q ratio is high, large losses are “no longer a tail event, but become an expected event.”

Figure 3 shows the magnitude of potential losses at various equity q ratios. In the last bucket (equity q > 0.9), the expected (median) drawdown is 20 percent, with a 1/5 chance of a greater than 40 percent correction in the S&P500 within the next few years. Spitznagel describes Figure 3 as “[t]he best picture I have ever seen depicting the endogenous risk control to be had from Benjamin Graham’s margin of safety principle (which insists on cheapness to conservative fundamental assumptions in one’s equity exposures, and thus provides added protection against errors in those assumptions).

Equity q ratios over 0.9 lead to some very ugly results. So where are we now? I’ll discuss it later this week.

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Update: Now with a log version.

Here’s the St Louis Fed’s FRED on Warren Buffett’s favored market measure, total market capitalization-to-GNP.

FRED Graph

According to the FRED data, the Q1 2000 TTM/GNP peak ratio was 158 percent, and the Q3 2007 TTM/GNP peak was 114 percent. The average for the full period – Q3 1949 to Q3 2012 – is 69 percent. The last time the market traded at a below-average ratio was Q1 2009.

Compare this to the Q3 2012 ratio – unfortunately the most recent point – at 100 percent. If we assume ~1 percent GNP growth in Q4 2012 and Q1 2013 (the long-run CAGR is about 1 percent per quarter), and the market has rallied around 10 percent, the ratio now stands at ~107 percent, which is around 40 percent over the long-run mean (since 1949). This level of overvaluation accords with the level of the Shiller PE and Tobin’s q at 40 and 44 percent respectively.

Here’s the log version, per commenter Jim’s request:

FRED Graph

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