Timing the market isn’t easy. In fact, it’s probably one of the hardest things you can do.
There’s no shortage of people who attempt to do it, though. In truth, when the market is expensive, so too are individual stocks. So, naturally, one would like to buy when the market is cheap and sell when the market is expensive, whether you’re holding indexes or buying individual equities.
Top Down Market Valuation Metrics
Recently, I’ve heard a lot about the Shiller PE ratio, a backwards looking ratio built on top of a normal price-to-earnings ratio. The Shiller PE is cyclically-adjusted. It uses 10 years of past earnings, adjusts for inflation, and then divides the 10-year average earnings by stock prices to come to a simple ratio.
The Shiller PE is naturally more conservative than other valuation metrics. In using a 10-year average, it automatically adjusts for booms and busts, as they tend to happen every few years. The last 10 years would include low earnings from 2003, higher boom earnings from 2005-2007, and then depressed earnings from 2008-2010.
The Schiller CAPE ratio would tell you to buy when stocks trade for below the median cyclically-adjusted earnings and slow your purchases, or sell, when stocks trade above the median.
Right now, the CAPE as reported by Multpl.com is 19.35, well above the 14.51 median.
CAPE has some weaknesses. It doesn’t take interest rates into consideration, only a proxy for interest rates – inflation. The historical median of 14.51x cyclically-adjusted earnings happened in periods where interest rates were higher, so naturally earnings multiples were lower. Now, with interest rates at historic lows, earnings multiples should be higher.
What’s Buffett Say?
Warren Buffett may be all about the qualities of individual companies, but he also looks at top down valuations when making purchases on the open market.
His favorite ratio is the market cap of all American equities relative to the gross domestic product (all economic output) of the United States. Currently, the total market cap to GDP ratio tells us that the markets are slightly overvalued.
Interestingly, the ratio is back to its 2007 peak, but still much lower than its dot com bubble high.
There are some obvious weaknesses to this valuation metric. The companies that make up the total market cap of the US markets do business all around the world. Also, it excludes the valuation of private companies, which make up a substantial share of American GDP. In the last decade, acquisitions and take private transactions have taken hundreds of companies off the public markets. These companies are thus excluded from total stock market capitalization.
Finally, it does not adjust for interest rates or alternative investments. If the only alternative is to earn 3-5% by locking up your investment capital for 20 years in corporate or US Treasury debt, paying a higher price for a business isn’t such a terrible alternative.
Using Top Down Ratios as a Guide
Top down investment ratios are best used as a guide than a rulebook. If you look at either the Shiller PE or the total market cap to GDP, you find that stocks are only slightly pricier than historical levels. In a low interest rate environment, one could reasonably call that “fairly-valued.” Investors should expect long term rewards in stocks at or slightly below the long-term averages going forward.
These two metrics are perhaps best used to find places to buy more rather than to sell. Total market cap to GDP is much better at finding tops and bottoms than the Schiller PE ratio, which would have indicated that stocks were extraordinarily overpriced in January 2009. Since then, the stock markets have more than doubled. Buffett’s total market cap to GDP would have told you to be a heavy buyer of stocks during the financial crisis.
All in, no valuation metric is perfect. Markets are at the whim of participants, people who were willing to purchase dot com stocks for triple digit earnings multiples and sell high-quality blue chip stocks for single digit earnings multiples in 2009. But one should keep an eye on top down valuation measures, if for no other reason than to confirm an investment idea that already makes sense to you – long or short.
What are your thoughts on these top down approaches?