U.S. Stocks: Not Cheap vs. the Economy

Cheap-money hangover continues...

The STOCK MARKET has taken a good cowhiding this year under the Federal Reserve's pitiless onslaughts, writes Brian Maher in The Daily Reckoning.

The Dow Jones has hemorrhaged some 6,500 points year to date. Both S&P 500 and Nasdaq Composite have absorbed similar blasts on a percentage basis.

Trillions in stock market wealth have vanished into the great nothingness...whence it sprung.

And so the delirious excesses of the past several years are wringing out of the financial system.

Yet are they?

Mr.Warren Buffett's preferred market barometer – the "Buffett Indicator" – stacks stock market valuations against the gross domestic product.

A reading of "1" indicates a stock market and economy marching in step, neatly formationed.

A reading below 1 indicates an undervalued stock market against the economy underlying it. Stocks are bargains.

A reading above 1 indicates an overvalued stock market against the economy underlying it. Stocks are dear, costly.

This gauge read 2.1 prior to the 2000 collapse with its horrific overvaluations in the technology sector. That is, total stock market capitalization registered 2.1 times GDP.

How much have stock valuations plummeted against the gross domestic product of late? What is the Buffett Indicator's present reading...after this year's stock market shakes?

Your choices are these:

A) 0.9
B) 1.2
C) 1.5
D) 2.2

In reminder: A reading below 1 indicates an undervalued stock market. A reading above 1 indicates an overvalued stock market.

Recall, stocks turned in a lean, lean year. The stock market has certainly fallen into tighter alignment with the economy.

Have you made your selection? We now confess to a deception. We have unfairly and dastardly taken you for a sleigh ride.

The answer is "none of the above."

Here then is the answer – and recall that a reading below 1 indicates an undervalued stock market and a reading exceeding 1 indicates an overvalued stock market:

The answer is 2.44.

That is, today's reading exceeds even the outrageous 2.1 of 2000.

That is, the stock market remains vastly overvalued against the economy – despite this year's tremendous coming down.

It seems impossible. Yet there you are. Mr.Lance Roberts of Real Investment Advice:

"The Buffett Indicator is a valuation measure that compares the stock market's capitalization to the gross domestic product. A favorite of Warren Buffett, the indicator sits shy of 2.44 times market cap to GDP...Even after the recent fall in markets, the ratio is still one of the highest on record, north of the 2.11 level recorded during the dot-com bubble of 2000, and considerably elevated compared to the average since 1950.

"The Buffett Indicator tells us that overvaluation is not sustainable when the market capitalization of stocks grows faster than what economic growth can support...Today, investors are paying almost 2.X what the economy can generate in revenues and earnings."

Here is the coda, the venom sting in the tail:

"Stocks are far from cheap. Based on Buffett's preferred valuation model and historical data, return expectations for the next 10 years are as likely to be negative as they were for the 10 years following the late '90s."

Take it all aboard. Chew it, down it, digest it. Are you eager now to "buy the dip"?

Roberts sketches a dark scene of the coming decade:

"Yet this Buffett Indicator does not forecast an individual market cataclysm. It gives neither day nor hour.

"It merely takes the overall view, the long view. And that view affords a glimpse of negative real returns for the decade ahead."

That is, it gives no forecast of tempests or squalling rains – but more of what Melville labeled "a damp, drizzly November."

Only the damp, drizzly November endures a decade.

"If returns over the next 10 years revert back to historic norms..." adds Michael Lebowitz of the same Real Investment Advice, "we should expect annual returns of negative 2% for each of the next 10 years."

Meantime, famed money man Stanley Druckenmiller gives a similar forecast:

There's a high probability in my mind that the market, at best, is going to be kind of flat for 10 years, sort of like this '66-'82 time period.

The foregoing centers on one fundamental concept: "Reversion to mean" – and the punishing laws of probability.

The scales will once again balance even and extremes iron out. The great equalizer of time will level things out...

That which goes up comes down, that which goes down comes up. Mountains rise, mountains crumble, the meek finally inherit the Earth.

That is why we are certain today's extremes will not persist. We do not know when they will end. We know only that they will end. And watch out.

As we have noted before:

The mills of God grind slowly. Yet they grind exceeding small.