Monday, January 2, 2012

Stock Market Valuation Relative to GNP

One metric in assessing stock market valuation is to compare total stock market capitalization to GNP.  From Pragmatic Capitalist is a graph showing the history of stock market capitalization vs GNP:

Apparently this is one of Warren Buffet's favorite valuation metrics and he considers a ratio below 80% a sign of good value.   But you can see that the market has had historically high valuations for 20 years now.  Notice a peak is in 2000, another lower peak in year 2007 and a yet lower peak now.  Today we're back over 100%.    To get back to historic valuations, the market would need to drop about 50% to get the ratio back to the historical range! Alternatively, the economy needs to double in size with stock prices remaining constant.

I believe that we're in a secular bear market with a probable duration of 17 years from Year 1999 (similar to 1964 to 1981 where the market went nowhere for 17 years).    I also think there's a chance that the market will ultimately drop 60 to 70% to re-attain historic valuations in terms of the above ratio and dividend yields.

Market falls of 70% appear to be common after speculative bubbles (Nasdaq in 2000, Japanese Stocks, China Stocks).   Interestingly, the Shanghai Composite index is approaching a 70% decline (not quite but headed that way) from a peak in 2007.   It's usually safe to "go into the water" once that magnitude of decline has occurred (except for Japan where the market has declined even further than 70%).   Have a look:

Be careful out there!

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