The best pundit to ask about whether stock markets have become bargains may go by the initials GDP.
And the granddaddy of economic indicators is saying that despite the rapid selloff in the markets in the past few weeks, stocks are still overvalued – and have been for years.
David Rosenberg, chief economist at Gluskin Sheff + Associates Inc., says the ratio of the market capitalization of U.S. equities to U.S. gross domestic product has been far above its historical norm for more than two decades. And while this ratio has been trending lower since the end of the dot-com bubble – perhaps helping explain the lacklustre market returns of the past decade or so – it still has a long way to go before stocks look fairly valued relative to the overall economy.
“We’re still working through that excess,” he said – arguing that markets could be in a lengthy “sideways market” until the market’s value gets back down to its historical norms versus GDP.
“It’s all part and parcel of the secular bear market,” Mr. Rosenberg said.
The idea that long-term GDP trends would be a key to stock valuation is hardly new. Academic formulas for calculating stock values have long included expectations for GDP growth as a key component (along with other factors such as interest rates, dividend growth and risk premiums).
“It really boils down to two components: Growth and risk,” said Stephen Foerster, professor of finance at the Richard Ivey School of Business at the University of Western Ontario. “Most of the market moves you see from day to day can be explained by one or the other.”
Prof. Foerster said that as corporate profits have grown as a proportion of U.S. GDP over the past couple of decades, GDP growth has become an even stronger indicator of market valuation. The post-recession earnings recovery of the past two years has driven corporate profits, as a percentage of U.S. GDP, to historical peaks.
Indeed, the rise in corporate earnings relative to GDP is one explanation for why equity market valuation relative to GDP surged in the 1980s and 1990s. Legendary investor Warren Buffett cited this rise more than a decade ago as a major reason why the market had outperformed the economy. But he also warned that the trend was destined to fizzle out and revert to historical norms, which would mean a retreat in stock valuations relative to GDP.
Another possible driver of the surge in the market-value-to-GDP ratio may have been the rise of the mutual-fund industry, which fuelled demand for stocks and may have elevated values beyond their historical norms, said Citigroup chief U.S. equity strategist Tobias Levkovich.
“Unfortunately, that development is not repeating itself,” he said in a recent research report.
The long-term link between stock values and GDP is at the heart of so-called “smoothed” or “normalized” price-to-earnings measures – the most commonly used being the Shiller cyclically adjusted price/earnings (CAPE) ratio, developed by famed Yale University economist Robert Shiller. The Shiller CAPE’s underlying assumption is that corporate earnings can be temporarily distorted, upward or downward, by the economic cycle. Using 10-year averages for corporate earnings, and comparing those to stock prices, smoothes out the distortions.
The Shiller CAPE is signalling that while stock-market valuations have cooled, they remain above their historical average – and are particularly steep if you believe the U.S. economy may be teetering toward another recession, Mr. Rosenberg said.
Even in the nearer term, both Mr. Rosenberg and Prof. Foerster said, GDP expectations are the key to assessing the market’s valuation – and a good reason to be hesitant about traditional price-to-earnings values that may look cheap at the moment.
“The [GDP] risks are to the downside,” Mr. Rosenberg said. “The economists have been lowering their forecasts, but the [stock] analysts have been slower off the mark.”
Prof. Foerster said that because GDP expectations are a component to calculating stocks’ fair value, uncertainty about the growth outlook has thrown a wrench into even non-emotional, mathematical attempts to measure value. And that, he argued, fuels the kind of market volatility we have witnessed in recent weeks.
“It may be that a greater range of opinions [about growth expectations] drive these gyrations,” he said.