Monday, October 13, 2014

Valuation

With the Dow Jones Industrial average negative for the year, I thought it would be a good time to highlight valuation. Doug Short recently updated a post on what he calls the Buffet Valuation Indicator. Doug starts the update with this:
Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment."
He goes on to write:
In a CNBC interview earlier this spring CNBC interview (April 23rd), Warren Buffett expressed his view that stocks aren't "too frothy". However, both the "Buffett Index" and the Wilshire 5000 variant suggest that today's market is indeed at lofty valuations, now above the housing-bubble peak in 2007. In fact, the more timely of the two (Wilshire / GDP) has risen for eight consecutive quarters and is now approaching two standard deviations above its mean -- a level exceeded for six quarters during the dot.com bubble.
He ends with a chart showing this indicator compared to the S&P 500 with this:
One final comment: While I see this indicator as a general gauge of market valuation, it it's not useful for short-term market timing, as this overlay with the S&P 500 makes clear.
Read the whole post and review the graphs. Making a financial plan involves discussing how you'll react to downturns in the market and planning for 10% corrections and bear markets. When markets decline I feel the people who start deviating from their plan are the people who misunderstood their risk tolerance and do not have adequate emergency savings and/or cash flow. There are market forces that scare everyone, if you feel overly concerned when your portfolio declines you probably need to revisit your plan with yourself, your loved ones, or a qualified financial planner. Please also review some perspective from Barry Ritholtz who writes the Big Picture blog and recently wrote this piece for Bloomberg. He has 8 data points in his article and more wisdom at the end. I'll share two:
1. U.S. stock markets haven't experienced a 10 percent correction since October 2011.
2. As the "Stock Traders Almanac" is fond of pointing out, the six months that follow October are on average the best half of the year for equities. Whether that is because October affords a better entry price or is due to some other factor is both hotly debated and unresolved.

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