Market assessment

The ratio of total US market capitalization to US Gross National Product (GNP) is the preferred indicator for evaluating the US stock market. Warren Buffett.

Over time, corporate profitability returns to its long-term trend, which is around 6%. During recessions, corporate margins shrink, and during periods of economic growth, corporate profit margins expand. However, long-term growth in corporate profitability is close to long-term economic growth. The size of the U.S. economy is measured by gross national product (GNP). Although GNP is different from GDP (gross domestic product), the two numbers have historically been 1% of each other. For calculation purposes, GDP is used here. The U.S. GDP since 1970 is represented by the green line in the table below (GDP).

Total Market Capitalization (Wilshire Total Market) and US Gross Domestic Product (GDP)

Over the long term, stock market valuation reverts to its mean. A higher current valuation means lower long-term returns in the future. Conversely, a lower current valuation implies higher long-term returns. Total market value is measured by the ratio of total market capitalization (TMC) to GDP. It is Warren Buffett's favorite indicator of market valuation. This ratio since 1970 is shown in the table below.

US Total Market Capitalization (TMC) to US Gross Domestic Product (GDP) Ratio

We can see that over the last four decades, the TMC/GNP has varied within a very wide range. The lowest point was around 35% during the previous deep recession of 1982, while the highest point was 148% during the tech bubble of 2000. The market went from being very undervalued in 1982 to very overvalued in 2000.

Predicted returns and actual returns

In the table above, the green line indicates the expected return if market trends are toward undervaluation (TMC / GNP = 40%) over the next 8 years (which is approximately the length of a full business cycle). The red line indicates the expected return if market trends are toward overvaluation (TMC / GNP = 120 %) over the next 8 years. The brown line indicates the expected return if market trends are toward fair value (TMC / GNP = 80%) over the next 8 years.

The thicker light blue line corresponds to the annualized real return of the stock market over 8 years. The swing in market returns is linked to the evolution of interest rates. Performance has been disastrous for investors who entered the market after the late 1990s. Since then, the market has almost always been overvalued.. However, since October 2008, for the first time in 15 years, the market has been positioned to achieve positive returns.

source: gurufocus.com