Bull and Bear - TSP C Fund fedweek.com

Lyn Alden

One of the most important factors that determines stock market returns over the next 10 years is how expensive stocks are today.

Periods of low stock valuations, measured by various ratios such as a low cyclically-adjusted price-to-earnings ratio, low price-to-book ratio, low market-capitalization-to-GDP ratio, or high average dividend yield, have historically been associated with good stock market returns over the next 10-20 years. This is because there is plenty of room for corporate performance to grow and valuation multiples to increase.

On the other hand, periods of high stock valuation, like the years of 1929, 2000, or 2007, have historically been associated with rather poor stock returns over the next 10-20 years. And this is because stocks are already starting from a high point, usually late in the business cycle, and with high valuations that are more likely to contract rather than expand.

Despite the recent 10%+ price decline we’ve seen in many U.S. market indices over the past few months, U.S. stocks are still at historically elevated levels based on most metrics.

This is partly due to historically low interest rates, but also likely has to do with where we are in the business cycle.

One back-of-the-envelope way to measure stock valuation levels is to divide the total U.S. stock market capitalization (the value of all shares of all stocks, roughly equivalent to the companies in the C Fund and S Fund combined) by the country’s GDP. Warren Buffett popularized this metric years ago. This gives investors a rough idea of how expensive stocks are compared to how much economic value is actually being created.

Here’s a chart of the Wilshire 5000 index which roughly measures total U.S. stock market value (blue line) alongside the GDP of the United States (red line):

Sources: US Bureau of Economic Analysis, Wilshire Associates, St. Louis Fed

At the height of the dotcom bubble in 2000, the value of stocks was about 150% of the GDP, which was the highest the ratio was ever at in the United States. Over the next couple of years during a mild recession and big downward re-adjustment in stock valuations, this fell to 75%.

Then at the height of the subprime mortgage bubble in 2007, stocks were about 110% of GDP and fell to under 60% of GDP during the depths of the subsequent financial crisis. Stocks never got quite as high with this bubble because most of the enthusiasm was focused on real estate.

A few months ago in September 2018, the stock market was worth just under 150% of GDP again; only slightly less than it was during the height of the dotcom bubble. As of this writing in December, the ratio has fallen to a little over 130%, which is still one of the highest levels on record.

It’s important for investors to be aware of the volatility and risks of investing in equities, especially late in the business cycle when they are expensive. If stocks were to fall back down to an equivalent of 100% of GDP during the next recession, that would mean a 20%-25% stock market decline from here. If they were to fall further, to 75% or below, that would roughly equate to a 40-45% sell-off or more.

No valuation metric is perfect, including this capitalization-to-GDP ratio. For example, if U.S. companies were to increase their share of revenue from outside of the United States, then it would make sense for their valuations to permanently inflate compared to U.S. GDP over time. However, that hasn’t been the case in the past 10-20 years. According to S&P Dow Jones Indices, large U.S. companies earned about 44% of their revenue from outside of the United States in 2017, compared to about 46% in 2007.

If you go back several decades, it would look very different, but going back just 10-20 years is truly an apples-to-apples valuation comparison because the ratio of domestic revenue and international revenue is approximately equivalent. Even just five years ago in mid-2013, stock market capitalization was equal to GDP, where the blue line and red line were equal.

In addition to still having a high ratio of market capitalization to GDP, U.S. stocks still collectively have a high cyclically-adjusted price-to-earnings ratio, high price-to-sales and price-to-book ratio, and low dividend yields.

Lifecycle funds and other diversified portfolios can mitigate some of this volatility for investors. After a decade-long bull market and economic expansion, although we don’t know what the future holds over the next few years, it’s important for investors to be aware of the risks involved with investing.

And before making major life decisions like retiring or changing jobs, it’s important to assess how your portfolio and wealth would respond to a recession, to ensure that even in not-so-rosy economic scenarios, your portfolio is prepared to meet your financial goals.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.