Is the U.S. Stock Market Currently in a Bubble? (Part 2)

Expanding on my previous post, let’s look at a few other measures that can give us an idea of the current state of market valuations.

The Ratio of Market Capitalization to GDP

In a Forbes interview, Warren Buffet described this ratio as “probably the best single measure of where valuations stand at any given moment.”  It’s simply the total market capitalization of the stock market divided by GDP.  The following chart shows how this measure has varied over the years and where it currently stands.  Below that is a chart of the S&P 500.


Market Cap / GDP Ratio, Source:


S&P 500, Source:

As we can see, this ratio is the highest its been since around the year 2000.  It suggests that market prices are rich relative to GDP at the current moment.  Of course that doesn’t mean that stock prices are ready to crash, just that investors should be cautious.

John Hussman, a stock market analyst and fund manager ( says that annual returns are driven by the following:

1.  Growth in nominal GDP

2.  The reversion in the ratio of market capitalization to GDP toward its historical norm

3.  The annual dividend yield

For a 10 year horizon, the formula can be written out as:

The historical norm of the market cap to GDP ratio has been about 0.63.  In early 2000, it hit its highest level of 1.54.  At that point, the dividend yield for the S&P 500 was 1.1%.  If we assume a generous nominal GDP growth of 6.3%, Hussman says that an estimate of the subsequent 10 year annual return could have been calculated as follows:    (1.063)(0.63/1.54)^(1/10) – 1.0 + .011 = -1.7% annually.  This means pretty much negative to flat returns for a decade.  Sure enough, the actual total return of the S&P from 2000-2010 was still negative even after bouncing back from the March 2009 lows.

Hussman then provides a valuation study for 2014.  The current market cap to GDP ratio is 1.25, about double its historical norm of 0.63.  If we assume nominal GDP gets back to a healthy growth rate of 6.3% and with an S&P dividend yield of 2%, we can estimate the following 10 year return to be:

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually

In other words, according to this, we can expect pretty anemic returns for the next decade at these levels.  Off course, if the market sells off drastically, investors getting in at better levels can expect to achieve greater returns.

The chart below from John Hussman’s website is instructive.  It shows projected 10-year return based on the formula above against the actual 10-year return that occurred.  As we can see, the two lines correlate pretty well with each other, so the formula does a pretty good job of predicting what the return will be based on current market cap / GDP and dividend yield.  Based on current stock market valuations, the chart and formula is predicting low single digit returns over the next 10 years.

Projected and Actual Returns for the S&P 500, Source:

Projected and Actual Returns for the S&P 500, Source:

Corporate Profits to GDP

Another area where we see evidence that the U.S. market may be overvalued is company profits.  The corporate profits to GDP ratio is at all time highs.  Profit margins are cyclical and mean-reverting, so they’re not likely to remain at these levels forever, unless something fundamentally has changed and companies can expect permanently high profit margins.


Corporate Profits to GDP Ratio, Source:  St. Louis Fed

Corporate Profits to GDP Ratio, Source: St. Louis Fed

The Current Market Is Still Not As Frothy as in 2000

Although valuations may be rich, we still aren’t seeing the same maniacal prices for tech stocks especially as exhibited in 2000.  From a recent BBC article, Kathleen Smith of IPO investment advisory firm Renaissance Capital says there have been 53 listings of IPOs so far in 2014 which is half what we had for the same time period during 2000.  Also, the price performance of newly-listed shares isn’t as extreme as in 2000.  In 1999, more than 100 companies saw their share price double on the first day.  In 2000 there were 80.  So far this year, there have only been 4.  (

It also seems like large-cap stocks are still reasonably priced.  Based on data from the Bespoke Investment group from a New York Times article:

In 2000, the 10 biggest stocks in the S&P 500 had an average P/E ratio of 62.6. Today, that number is only 16.1.

Today, only one stock among the largest 10 stocks has a P/E above 30: Google. (

I did a Google Trends search to see how often the term “Stock Bubble” was searched for and came up with the following chart:

"Stock Bubble" Search Interest, Source:  Google Trends

“Stock Bubble” Search Interest, Source: Google Trends

After the peak in interest in middle 2007, the years 2008 and 2009 were some of the most turbulent market periods in history.  For 2010, 2011, and 2012, we don’t see much interest in the term, until late 2013, where searches for “Stock Bubble” increased again.  Not to say that this is predictive of a market crash in any way, it was just something I found interesting to note.


Overall, I think that investors need to be cognizant of the fact that the market is valued more richly than in the past few years, especially certain sectors such as internet and biotech.  At least part of this recent bull market has been the result of easy money policies by the Fed.  Interest rates are bound to increase at some point and that will put pressure on corporate profits and stock prices.  This doesn’t mean you should dump your stocks however, especially if you have a long-term time horizon and a diversified portfolio.  If you do, then a 30% or more market correction should not scare you and will actually be an opportunity to get in at better levels.  If however, you are close to retirement, then considering moving a part of your portfolio into cash or safer assets may be a prudent strategy.


Investing Wisdom Takeaways from Warren Buffett’s 2013 Letter to Shareholders

Warren Buffet’s annual letter to shareholders of Berkshire Hathaway has been a treasure trove of investment wisdom since 1965.  In addition to Ben Graham’s writings, these are required reading for all value investors.  With the annual Berkshire shareholder meeting coming up on May 3rd, I thought I’d highlight some key points he makes in this year’s letter.  If you haven’t downloaded it yet, here’s the link:

WB:  “You don’t need to be an expert in order to achieve satisfactory investment returns.”

You don’t need to be a hedge fund quant in order to generate great returns over the long-run.  Stick to what you know inside your circle of competence, and if you don’t understand an investment, move on.

WB:  “Focus on the future productivity of the asset you are considering.”

You should be able to make a rough estimate of what an asset’s earnings or cash flows will be over the next few years.

WB:  “If you instead focus on the prospective price change of a contemplated purchase, you are speculating.”

Don’t speculate what the future price may be of a particular stock.  Support or resistance  or any type of technical analysis shouldn’t be a justification to invest.  Approach an investment from the standpoint of owning a piece of a business.  As Ben Graham taught Buffet:  “Price is what you pay, Value is what you get.”

WB:  “With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations.”

How often do we stay glued to our stock quote screens obsessing over daily fluctuations in the market?  Mr. Market may be perfectly rational one day and psychotic the next.  Get away from the chaos of daily price movements, look at the big picture, and have a long-term perspective.

WB:  “Forming macro opinions or listening to the macro or market predictions of others is a waste of time.”

'And there you have it. According to our experts, the stock market will either advance, decline, or remain unchanged this year.'









This is probably my favorite piece of advice.  The world is a chaotic place and there are so many variables at play in the complex behemoth that is the global economy, that making macro predictions or listening to people making predictions about the market is a waste of time.  No one can control what goes on in the world and how the economic winds blow.  What you can control is how you allocate your capital.  Successful value investors make decisions using a bottom-up approach, analyzing each investment based on its own merits.

WB:  “Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well.  Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and worse yet, important to consider acting upon their comments.”

There is a lot of noise out there about markets and the economy.  Watching CNBC or Bloomberg all day can make your head spin from all the information being spewed your direction.  It may make you feel like you need to take action, to do something, anything, in reaction to market events and opinions.  Of course banks and brokerages and trading platforms profit more when you trade actively so it’s encouraged.  However, active trading and the resulting large transaction costs will kill you.  The more you trade, the less you’ll make.

In reality, all that chatter should matter very little to how you allocate your capital.  Do your own homework and don’t blindly listen to so-called experts.


WB:  “The goal of the non-professional should not be to pick winners……but should rather be to own a cross-section of businesses that in aggregate are bound to do well.  A low cost S&P 500 index fund will achieve this goal……Following those rules, the “know nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.  Indeed the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long term results than the knowledgeable professional who is blind to even a single weakness.”

In the end, most investors will perform better by simply staying invested in the general market.  However, there’s nothing wrong with having an opinion on certain stocks and investing in them.  Just make sure you’ve done your homework and given yourself a large margin of safety so that if you’re wrong, the financial hit won’t take you out of the game.  Overconfidence and other biases give investors false confidence in their investment decision-making capabilities.  Before making an investment, ask yourself:  “Is there a place I stumbled in my analysis or have I overlooked a hidden risk?”  Even if you’re confident, an investment in one stock should never comprise a significant portion of your net worth.