Market Valuations17 Mar 2020
I was doing some rough analysis of market valuations today compared to historical norms using a few long-term metrics that I like to monitor. These metrics are not timing signals, nor do they tell you where the market will go next. They are useful to understand where we are in the cycle and where we currently sit on the valuation spectrum.
This analysis is done only looking at the S&P500 Index, as a proxy for “markets”. Today the S&P500 closed at: 2529.19
CAPE (Shiller P/E)
CAPE is a crude metric that just tracks the price vs the 10 year trailing earnings. This smooths out business cycles, and has proven to be a pretty good, but fuzzy, indicator of where business valuations stand relative to their long term, durable, earnings power. As you can see below, we’ve seen a significant improvement in this metric over recent weeks, but still remain in overvalued territory.
The historical mean for CAPE going back more than 100 years has been 17. Today we stand at 24.2, which is 42.6% higher than the mean. A reversion to the historical mean would require a further 29.8% (42.6/142.6) decline from today’s (3/17) close. This would take the S&P 500 to $1775.49.
At the 2007 market peak, the CAPE was 27.4 – not much higher than where we still stand today. At the market’s bottom in 2009, the CAPE touched 13.30 (but not for long!), which was below the long term mean of 17, and considered undervalued. If todays S&P500 were to reach to a 13.3 CAPE, with present 10-year earnings, the S&P500 would need to fall to $1390.00, or another 45% from todays prices.
Market Cap / GDP
Another indicator, made famous by Warren Buffett, is the proportion of the total Market Cap of all stocks relative to the US GDP. This is also a very crude metric, which can be impacted over time by things like private companies staying private longer (and being bigger), and public companies doing more and more business internationally, but I think it is still a useful heuristic to look at and consider. There are also counter-effects, such as government spending becoming a larger and larger portion of GDP, which would have the effect of moving this average down (businesses make up a smaller portion of GDP). Below you can see the historical total market cap in blue, and US GDP in green.
Another way to look at this is by plotting the ratio between the two. The historical average ratio is around 0.8 – that is, where the total market cap of public stocks is around 80% of US GDP.
At present, the total market cap is 115.9% of GDP, which is 30.9% ((115.9-80)/115.9) above the historical average of 80%. If we use the S&P500 as a proxy for total markets, it would need to fall to $1745.77 to be valued at the historical average levels using this metric. The present valuations, using this metric, are still higher than they were at the peak of the market in late 2007 (the total market cap was 110.10% of GDP then)!
At the market’s bottom in 2009, the market was valued at 57% of US GDP (and GDP had contracted, as I’m sure you’re aware). To get to an undervaluation of 57% of current GDP, with no contraction in GDP, the S&P500 would need to fall another 50.82% to $1243.86.
It’s interesting that both of these valuation metrics, give very similar numbers for “fair value” on the markets of around $1745-$1775 on the S&P500, based on current GDP, and current trailing earnings. They also give similar “undervaluation” prices, if we were to assume we achieve valuations similar to those reached in 2009, which would put the S&P500 in the $1250-$1400 range. Note that the 2009 undervaluation was relatively brief, and less severe than virtually all recessions before it, with the 2000-2003 recession being the exception.
In 2008/2009 the market only went below the mean for < 12 months (around Dec 2008 - July 2009 on both metrics). The 2000 recession actually never reverted fully to the mean in CAPE valuations (seeing a low of around 21), but did go a bit below the mean in terms of Market Cap / GDP. With the benefit of hindsight, we know now that it would have been quite prudent to have invested during either of these windows.
Finally, I want to stress that the numbers above are not predictions! They are just simple mathematical extrapolations of historical data, assuming certain mean reversions were to happen. The market can stay overvalued (or undervalued) for quite some time, and there’s no rule that these levels have to be hit, and certainly no indication on timing if they do. There are also many other valuation metrics out there, but, I tend to favor a long-term mindset, and think that markets will continue to be weighing machines in the long term and voting machines in the short term.
With everything going on with Coronavirus in the markets, I find it useful to keep an eye on the long term, and to understand that “this, too, shall pass”. There will be short term pain, but the long term value of good businesses will be little changed (see here, for a good case as to why that is here).