Market sentiment was still influenced by memories of the Great Depression and investors were looking for income and safety. Stocks, being riskier than bonds, were expected to provide a higher yield.
“Only in eight of the past-nine years have stocks sold so high in terms of dividends. Only for short periods in 1929, 1930, and 1933 have stocks yielded less than government bonds.”
With the dividend yield below the bond yield, was the market headed for another crash?
“It has been practically an article of faith in the U.S. that good stocks must yield more income than good bonds, and that when they do not, their prices will promptly fall.”
But sentiment was changing. Institutional investors were increasingly investing in equities for their growth, rather than their dividend yield:
”A more basic reason for the market’s strength was the phenomenon largely responsible for its unprecedented rise in 1958: a growing belief that the time had at last arrived when quality stocks, because they appreciate in both intrinsic and market value, should normally sell to yield no more – or even less – income than bonds.”
“Although [pension funds, mutual funds and life insurance companies] together hold only some 10% of all the stock outstanding in the U.S., they have been increasing their share of the total rapidly. They have become a dominant force in the stock market… they are accounting for more than half of the net purchase of equities.”
The recession of 1958 was mild and earnings recovered quickly. Optimists were ready to discard the fear that every recession could be the next Great Depression:
“The specter of economic catastrophe that has haunted the U.S. since the 1920’s now appeared to be only a bogeyman.”
“Suppose, that investors cease to fear massive declines in earnings. The risk premium is then clearly unnecessary, and stock prices can be bid up to much higher price-earnings ratios.”
However, Fortune noted that the same sentiment had prevailed in the 1920’s:
“The doctrine that equities should be valued for more than mere yield, furthermore, is by no means new. It was the subject of a much-discussed book published in 1926, Edgar Lawrence Smith’s Common Stocks As Long-Term Investments, and it was a doctrine that helped whoop up stock prices to absurd levels in 1929.”
And not everybody agreed:
“[He] maintains that inflation is not so “inevitable” as it is cracked up to be, that bonds should by nature yield less than stocks and that the present market is headed for a major readjustment.”
But stocks did not fall. There was no major readjustment. Instead, the economy kept expanding, earnings kept growing, and the 1960’s brought the first speculative bull market since the 1920’s. Meanwhile, bond yields were just beginning their ascent. The “article of faith” stopped working.
Today, nobody argues that the stock market should yield more than the bond market. But other indicators are being used as rules of thumb to judge whether the market may be at an extreme. Typically, these charts show a compelling and simple relationship that appears to identify cyclical market peaks and bottoms. I will touch on a few of the charts I encounter on a regular basis. My point is not to argue whether the U.S. stock market today is expensive or not, but merely to point out flaws in these indicators that suggest an easy answer.
Stock Market vs. GDP
This is how Buffett described the ratio of the stock market to GNP in 2001:
“The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.
If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire. As you can see, the ratio was recently 133%.”
This measure has since become known as the “Buffett Ratio” (most charts use GDP instead of GNP, hence the different percentages from Buffett’s quote). One obvious issue with this ratio is that it compares companies with increasing international exposure to domestic economic activity. Another potential issue revolves around higher corporate profit margins. While profit margins fluctuate with the economic cycle, changes in industry composition and industry concentration could be elevating margins long-term.
Share of foreign profits rising:
“In 2017, the percentage of S&P 500 sales from foreign countries increased slightly, after two years of measured decreases. The overall rate for 2017 was 43.6%, up from 43.2% in 2016, but down from 44.3% in 2015 and 47.8% in 2014, which was at least an 11-year record high. S&P 500 foreign sales represent products and services produced and sold outside of the U.S.“
“Over 75% of U.S. industries have registered an increase in concentration levels over the last two decades. Firms in industries with the largest increases in product market concentration have realized higher profit margins, positive abnormal stock returns, and more profitable M&A deals, which suggest that market power is becoming an important source of value.”
Corporate profits as a share of GDP:
Changing sector composition in the U.S.:
Comparing Stock Market Valuations
Another type of chart I encounter in conversations about asset allocation compares the valuation of the U.S. stock market to international peers (often the ACWI ex-US or emerging markets). Over the chosen time frame (1995-2018) the message seems obvious: the U.S. is historically expensive and it’s time to bet on mean reversion.
WSJ/Bank of America
Lawrence Hamtil discussed the flaw in this argument in his blog: aggregate market valuations are not directly comparable due to the differences in sector composition. The sub-industry composition can also be very different (for example, consumer discretionary can be weighted towards automotive components vs. internet retail).
“The U.S. market is obviously very heavy in tech and health-care stocks, which historically have traded at premium valuations, while the rest of the developed world is heavy in financial and industrial stocks, which tend to trade at discounted valuations.”
“It is a common, - but false, - belief that global equity markets are somewhat interchangeable, and all an investor has to do to earn superior returns is to shift capital to whatever may be cheapest.”
“So, yes, U.S. stocks are expensive, but the rest of the world looking cheap by comparison does not automatically make it a bargain.”
Stock Market vs. Commodities
These charts compare the stock market with a commodity index. They seem to make a compelling argument: are commodities historically cheap and about to rally dramatically (or are stocks perhaps about to crash)?
However, as Sri Thiruvadanthai pointed out, these charts are flawed as they compare a total return index (GSCI Total Return Index) with stock price indices.
In his words:
“Here is the corrected version. Does it suggest anything to you?”