I still remember it vividly. My wife and I were staring at a map of the Tokyo subway system. After arriving at Tokyo International Airport, our task was to get through the subway system to Narita International Airport. Her sister was eagerly waiting in Okinawa for the arrival of our connecting flight. Sounds simple enough. Except, we were using a subway system we had never seen before.
Staring at the sizable map of complex tunnels – with nearly everything written in Japanese characters – we eventually identified our destination. Feeling good about ourselves, we then realized we had forgotten to gather an important piece of information. Sometimes, figuring out where you’d like to go is only half the battle.
Destiny: DOW 30,000?
Recently, a flurry of predictions have the Dow Jones Industrial Average (a popular benchmark for US stocks) on its way to 30,000. The reasons for this optimism are diverse and largely contradictory, but wishful thinking often is. Since the election of Donald Trump, the stock market is up big thanks to improved consumer confidence, promises of regulatory and tax reform, and the relative certainty that comes with the resolution to a tumultuous election cycle. When the market broke above 20,000 a few weeks ago, many saw it as an indication that this bull has room to run. While there may be some truth to this, it is, as they say, not that simple.
Location: DOW 21,000
Currently, the DOW average is hovering around 21,000. This means the market would need a roughly 43% rise to crest 30,000 – a feet not altogether out of the question. But while DOW 30,000 is where we want to go, does anyone care to know where we really are?
As my wife and I stared at the subway map of squiggly lines, we realized we didn’t know the Japanese character for “You Are Here”. And sometimes knowing where you are and knowing “You Are Here” are two different things. We knew we were somewhere on the map, of course. In the general vicinity of DOW 21,000, for instance. The problem was that we needed to be a little more specific. Today, the US stock market sits at all-time highs, surging past records and singing the siren song to any and all who will hear. We know the market is high, but is it too high?
In order to answer such a question, we need to look at where the economy is as whole. One good indicator is corporate earnings. Is the broad market (measured by, say, S&P 500) only 20% over-priced, as the forward operating earnings estimates indicate? If so, we could be headed higher. Bull markets have a tendency to do that. Or are the markets roughly 85% over-valued, as the much more accurate Shiller P/E indicates? The former would be bullish. The latter, a very hungry grizzly. The former could mean we’ll have a jolly old good time riding a wave of equity growth into the stratosphere. The latter could mean we’ll see DOW 10,000 first. Bottom line: before we can know where we are going, we need to figure out where we are.
Destination: Staring Into The Abyss
As you might have guessed, we put much more confidence in the Shiller P/E. It provides a much better forecast for market returns over the next 10-12 years. At this point, it suggests that in a decade the market will be 5-10% lower than it is now. To be clear, this is not a short-term forecast. Rather, it is a fundamental economic indicator that provides a very accurate estimate of returns over the next decade. In short, although DOW 21,000 is here for now, the underlying economic fundamentals indicate that the fair value of the DOW is somewhere around 10,000.
There is also another market indicator that isn’t mentioned all that much, but is perhaps even more accurate at predicting forward-looking market returns. It gained notoriety in the early 2000’s when Warren Buffett mentioned it as one of “the best single measure of where valuations stand at any given moment.” Below is a chart that illustrates Buffett’s favorite metric. It shows, essentially, the market value of all the publicly traded companies as a percentage of the country’s business (i.e. GNP).
As you can see, at only one time in the last 60 years were stocks more highly priced than today. In early 2000, the Tech bubble popped and the market dropped 50%. You may also notice the second highest peak – 2007 – when the market had a similar drop. And today? Well, let’s just say the market looks a lot like Wiley Cayote temporarily defying gravity.
It is a wonder, then, why Buffett recently said “stocks actually are on the cheap side compared to historic valuations.” Is this the same Buffett that claimed Market Cap-to-GNP was the “single best measure” of valuations? The same Market Cap-to-GNP that today signals extremely high prices?
Perhaps Buffett has bought into the argument that lower interest rates “justify” high prices in stocks. This view suggests that because the Federal Reserve pushed interest rates lower, stocks should be priced higher. As interest (i.e. returns) on bonds go down, individual investors should be willing to accept higher prices (and therefore lower future returns) on stocks as well. But this is like saying mustard must be good on an eclair because it’s good on a hotdog. There’s a certain logic to it, but you probably won’t be satisfied with the results.
While it is true that lower interest rates justify higher stock prices, simple math can tell us how much higher those prices should be. Without getting into the weeds, the prices of today’s stock market by most metrics would imply interest rates are going to stay near-zero for several decades. But no really believes that is the case.
Others, however, believe Buffett is more concerned with his legacy and doesn’t want to be the one to pop this bubble. In the past he has been hesitant to acknowledge bubbles until after they pop. There have also been reports that he is much more negative on the economy in private than he is in public. Regardless of the motivation, Buffett’s recent declaration that “stocks are on the cheap side” must be taken with a grain of salt. The old Buffett (that is, the younger one) of 15 years ago would beg to differ.
Getting There (Or Here) From Here
My wife and I eventually found someone who could speak “engrish”, a dialect not altogether different than what you might hear in the Appalachian mountains. Thankfully we were able to communicate with them just enough for us to identify our location, and begin our journey. In today’s market, everyone is talking about where we are going. DOW 30,000 has a nice ring to it. DOW 10,000? More of a screech. But if you can understand my financial “engrish”, that is where the map says “You Are Here”.
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