Market Indicators, Dec. 31 2011

There are three well-known ways of valuing the stock market that are based on publicly available information.

Two are based on earnings: 1) The ratio of total stock market capitalization to gross national product (GNP). The market cap. to GNP ratio was popularized by Warren Buffet. 2) A cyclically adjusted PE ratio (typically a 10-year PE ratio). The 10-year PE was popularized by Robert Schiller (but not first proposed by him).

The other ratio is Tobin’s Q, similar to a market price-to-book ratio. It measures the replacement cost of publicaly traded companies.

Taken as a whole, where do these indicators stand?

The total market capitalization of US stocks is approximately 15.5 trillion, as of the last trading day of the year.

The GNP at the end of SEP 30 was 15.4 trillion. In other words, the Buffet ratio ratio is roughly 1. According to Buffet, that is average; he considers a ratio of around .75 to be a good deal. In his 2001 article when the ratio was 1.3, he suggested the market might return 7% annually over ten years (it yielded around 2%).

Schiller publishes the 10-year PE ratio on his Web site. It is currently 21, in comparison to the historic average of 16.4. Again, the market seems to be overvalued, or at least no screaming deal.

Finding values for Tobin’s Q is a bit more complicated. There is a Web site run by Smithers & Co. (an asset manager) that tracks it. According to that source, the market is roughly 33% overvalued (it was 29% overvalued on SEP 30).

What other buy/sell signals are there for the market as a whole? Valuation indicators are bets on mean-reversion. What about betting on the trend? The market is just below its 200-day moving average. Nothing bullish there.

There is one overwhelming bullish economic signal. The yield curve is substantially positive. A difference of more than 65 basis points between the 3-month and 10-year Treasury is bullish. The current spread is 187 basis points. But, that is because the 30-day Treasury yields virtually nothing. This is an economic indicator, rather a stock market indicator per se, although it is histocially correlated with bull markets. It probably stimulates the market because the world’s main investment choices are corporate and sovereign, and sovereign debt is expensive when rates are low.

In summary, we enter the new year with the following picture:


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