Market Cap to GDP: The Buffett Valuation Indicator
(New Update)

From time to time I'm asked why I don't include Market Cap to GDP among the long-term valuation indicators I routinely follow. The metric gained popularity in recent years thanks to Warren Buffett's remark in a 2001 Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment."

Both the "Buffett Index" and the Wilshire 5000 variant suggest that today's market is at lofty valuations, now above the housing-bubble peak in 2007.

DYI Comments:  Excellent charts showing a very expensive stock market.  Poor returns going forward are now baked into the cake.  Buyer beware.

DYI 

Rethinking the 4% retirement spending rule

How much can I afford to spend in retirement? For all but the wealthiest, that’s the big question. 

For guidance, many retirees rely on the so-called 4% rule, which says you can withdraw 4% from your savings in the first year of retirement, and then give yourself an annual raise to account for inflation each year, without running a big risk of running out of money. 

But as asset values plummeted in 2008—and interest rates have remained at ultra-low levels—the 4% rule has been thrown into doubt. The big concern: For those with the bad luck to retire into a bear market, the danger of running out of money rises—even if one faithfully adheres to the 4% rule.

DYI Comments:  The reason is simple.  The 4% rule currently under more normal (lower) valuations makes all the sense in the world. Today of course between animal spirits and the Federal Reserves sub atomic low interest rates bonds and stocks are in nose bleed levels.  Anytime the 10yr estimated average annual return is lower than the 4% withdrawn figure you will be spending down your capital.  Unfortunately bonds are of little help as their expected return is less than the 4% threshold.  Until interest rates rise and/or improved stock returns a withdrawn of 1% or 2% is the most you can do.

Estimated 10yr return on Stocks

Using 5.4% as the historical growth rate of dividends and 4.0% as the ending yield.

Starting Yield*---------return**
1.0%-----------------------(-5.7%)
1.5%-----------------------(-1.7%) 
2.0%----------------1.3% You are here.
2.5%------------------------3.8%

3.0%------------------------5.9%
3.5%------------------------7.8%
4.0%------------------------9.4%
4.5%-----------------------10.9%

5.0%-----------------------12.3%
5.5%-----------------------13.6%
6.0%-----------------------14.8%
6.5%-----------------------15.9%

7.0%-----------------------17.0%
7.5%-----------------------18.0%
8.0%-----------------------19.0%

*Starting dividend yield of the S&P500-**10yr estimated average annual rate of return.

DYI

J. Paul Getty Quotes!

Stock Market - "For as long as I can remember, veteran businessmen and investors - I among them - have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips.

The professional investor has no choice but to sit by quietly while the mob has its day, until enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. There are no safeguards that can protect the emotional investor from himself."

Business - The #1 guideline to success is you must be in business for yourself. When you work for someone else, you sell your time at wholesale to your employer, who then re-sells it at retail to the customer."

Employment - "The employer generally gets the employees he deserves."
Technology - "In times of rapid change, experience could be your worst enemy."
Debt - "If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem!"

Corporations - "Going to work for a large company is like getting on a train. Are you going sixty miles an hour or is the train going sixty miles an hour and you're just sitting still?"

Children - "Money isn't everything but it sure keeps you in touch with your children."
Failure - "A man may fail many times but he isn't a failure until he begins to blame somebody else."
Humor - "The meek shall inheirt the Earth, but not its mineral rights!"

Innovation - "The man who comes up with a means for doing or producing almost anything better, faster or more economically has his future and his fortune at his fingertips."

DYI

We’re only in the bull market's 4th inning: Siegel

On Tuesday's episode of "Futures Now," the Wharton finance professor didn't just argue that stocks are cheap. He proclaimed that the Dow Jones industrial average will rise to his "fair market value" estimation of 18,000—10 percent above current levels—as companies continue to perform better and better.

 "I'm a bull, and I can't believe what S&P is putting out for earnings estimates in 2014," he said. "Operating earnings 2013 over 2012 were up 10.6 percent; S&P reported earnings were up 16 percent from last year. They're expecting reported earnings to be up 20 percent this year. We didn't have a real good economy last year, and we got 16 percent earnings growth. 

"If any of these earnings estimates pan out—and they are bullish—hey, we're in about the fourth or fifth inning of this bull market," Siegel added. "This could be ... much more than 18,000 on the Dow.

DYI Comments:  When it comes to the stock market anything can happen.  Here at DYI I weigh the odds both using math and historical valuation.  It is highly unlikely that we are only in the 4th inning most likely in 8th or 9th.  Jeremy Siegel has always been an optimistic guy and a well known perma-bull so nothing new there.  As the market gets closer and closer to the top interviews and bullish articles will increase in intensity until a super consensus is formed.  At that time caution will be thrown to the wind the top will be put in and after that there is no other direction to go but down.

Moneychimp.com has a inter-active site for determining the future returns of the market.  Using the current Shiller PE10 of 26, corporate profits growing on average 5% and current dividend yield of 1.9% the estimated 10 year average annual return for money invested today is 1.92%.  I agree with that assessment. Very difficult to launch a 4th inning bull market starting with those dismal returns.

DYI    

Margin of Safety!

Central Concept of Investment for the purchase of Common Stocks.

"The danger to investors lies in concentrating their purchases in the upper levels of the market..."

Stocks compared to bonds:

Earnings Yield Coverage Ratio - [EYC Ratio]

EYC Ratio = [ (1/PE10) x 100] / Bond Rate

2.0 plus: Safe for large lump sums & DCA

1.5 plus: Safe for DCA

1.49 or less: Mid-Point - Hold stocks and purchase bonds.

1.00 or less: Sell stocks - rebalance portfolio - Re-think stock/bond allocation.

Current EYC Ratio: 0.87

As of 03-1-14

PE10 as report by Multpl.com

Bond Rate is the Moody's Seasoned Aaa Corporate bond rate as reported by the St. Louis Federal Reserve.

DCA is Dollar Cost Averaging.

Earnings Yield Explained!

Benjamin Graham stated that before purchasing common stocks an investor would need to check to see if the earnings yield is greater than the bond interest by 50%. This is order to maintain a margin of safety which would cushion the investor from unforeseen economic or political events to prevent or minimize a loss.

To arrive at the earnings yield, it is simply expressed as (1 / PE ) x 100 = earnings yield. The earnings however, will need to be adjusted for inflation and cyclically averaged over 10yrs in order not to be lead into a peak earnings trap. This simple PE calculation is done by Multpl.com daily.

Compare that figure to the Moody's Seasoned Aaa corporate bond yield which is easily obtained from the St. Louis Federal Reserve. If you have an earnings premium of over 50% as compared to the bond interest, you are in a good position to add money to your broad based equity mutual fund and have a high probability of a positive outcome.

As soon as the earnings premium is less than 50% stop purchasing equities and shift your DCA dollars to bonds. As Benjamin Graham so elegantly stated: "The danger to investors lies in concentrating their purchases in the upper levels of the market..."

When bonds have an interest premium over the equities earnings yield, it is time to re-balance and/or re-think your stock to bond allocation. This movement between the two can take years; the only problem with this method is that the average investor may simply forget to make the change; or worse and go galloping away purchasing overvalued equities.

Some of you may have done your homework and tested this formula during the 1982 - 2000 bull market and concluded that it didn't work for the 50% earnings premium over bonds was seldom achieved. The investor did not fully participate in the great stock bull market of the 80's and 90's therefore it appears, that the formula doesn't stand up.

Here is the genius of Ben comes into play. the investor would have participated in the bond buying opportunity of a lifetime. This super bull bond market would have been the risk adverse investor dream come true. By purchasing the 30yr Treasury bond outright, and after one year had elapsed sell the bond and replace it with a fresh 30yr Treasury. You are purchasing the bond not for its interest but for the capital appreciation. As report by Jim Bianco of Bianco Research in Chicago, long-term government bonds gained 11.5% on average as compared to the S&P 500 increases of 10.8% during the last 30 years ending October 31, 2011!

Here at DYI we have deep dismay with the Modern Portfolio Theory(MPT) and their conjoined Efficient Market Theory (EFT) crowd (academia); they would have thought that the possibility of bonds out performing common stocks for that long of a time period to be an astronomical long shot at best. With the proliferation of computers and professors who have studied mathematics extensively it seems a shame not to put those skills to work whether they have any benefit. Warren Buffett has stated so directly in the appendix of The Intelligent Investor, "once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail."

To this end, we can state without equivocation, Ben, you are one smart cookie!

Mutual funds far outperform mutual fund investors

Why the average mutual fund gets better returns than its average investor

Index funds, and most ETFs, are based on passive strategies where low-costs should ensure that investors do better. But if investors are using ETFs and index strategies to make tactical investment decisions—tilting their portfolio to what they see as the “right” thing for now—the investor return numbers are proof that average investors only make those moves late.

Indeed, Morningstar research shows that investors do a good job of picking mutual funds, but a poor job in timing their moves between asset classes. 

As Kinnel noted, the bigger gap between fund and investor performance was no surprise. “Fund flows were going in all the wrong directions entering 2013. Investors were buying bond funds, selling U.S.-stock funds, and buying emerging markets. We know now that that was exactly wrong,” Kinnel wrote in a Morningstar commentary. “… That’s not to say that most people were going the wrong direction. In fact, most fund investors are rather patient folks who don’t make big moves from year to year. But those who did once more showed how hard it is to time the markets.” 

DYI Comments:  The shorter term your perspective is the lower your return will be.  In other words short term trading will kill off performance faster than a New York minute.  What DYI attempts to do is align our asset allocation based on historical valuation whether they be high or low.  Then we sit on that allocation for months only changing that allocation when valuation change.  No predictions are required simply increasing or decreasing along with the valuation changes.  This forces the practitioner to buy low and sell high.

Currently the U.S. stock market is at nose bleed level as shown by the Shiller PE10 at 25.87.  That is why our asset allocation model for stocks is at it's lowest level for stocks as returns going forward will be poor at best [until valuations improve].

All told, stocks and REIT's are overvalued.  Gold mining companies and long term bonds are pricey but have further to run on the upside before they end their secular bull market.

The great rises and falls of the market would not occur if it were not for the average investor and institutional investors behaving as neophytes.  As value players we desperately need performance chasers and despondent sellers.  Currently the performance chasers are in charge.

DYI    

Do Foreign Profits Explain Elevated Profit Margins? No. 

John P. Hussman, Ph.D.

We continue to view stocks as strenuously overvalued, but that alone does not drive our investment stance. What concerns us beyond valuations is the full ensemble of overvalued, overbought, overbullish conditions, coupled with textbook speculative features (soaring margin debt, heavy issuance of low-grade “covenant lite” debt, heavy initial public offerings of speculative companies), and growing internal divergences in price action and leadership. Our avoidance of market risk, and tightly hedged investment stance, does not reflect expectations of immediate market losses in this specific instance, but instead reflects the experience of severe average losses when similar conditions have been observed in a century of historical data. 

This time may be different. That is certainly the perennial argument, and at least in recent years, enthusiasm about quantitative easing has made it so. Still, we don’t observe any mechanism by which quantitative easing affects the economy or stock prices except by depriving investors of safe yield and making them feel forced to reach for yield in more speculative assets. This is essentially the same process that created the housing crisis, and we view the speculation in equities as equally severe today. Our concerns about market risk at present should be taken in the context of our great optimism about the prospects for strong investment opportunities over the completion of the present market cycle. The Hussman Funds remain defensively positioned in equities, with a moderately constructive stance toward Treasury securities and precious metals shares.

DYI Comments:  What John Hussman is saying, nobody rings a bell at the top.  It is better to look very stupid when these conditions prevail than really stupid after the losses begin to pile up.
Of course the rest of his article is always worth one's time.

DYI

Economist Caution: Prepare For 'Massive Wealth Destruction'

Take immediate steps to protect your wealth . . . NOW! 

That’s exactly what many well-respected economists, billionaires, and noted authors are telling you to do — experts such as Marc Faber, Peter Schiff, Donald Trump, and Robert Wiedemer. According to them, we are on the verge of another recession, and this one will be far worse than what we experienced during the last financial crisis. 

Marc Faber, the noted Swiss economist and investor, has voiced his concerns for the U.S. economy numerous times during recent media appearances, stating, “I think somewhere down the line we will have a massive wealth destruction. I would say that well-to-do people may lose up to 50 percent of their total wealth.”

DYI Comments:  DYI continues with our forecast of a peak to trough decline of 45% to 60% as stocks are now bid up to 1929 levels [except for the last 6 weeks before the peak in 1929].  The Fed's will not be able to come to the rescue as interest rates are now sub-atomic low levels.  Once sentiment swings to the bears no matter how much QE the Fed's throw at the banks stocks will drop until the bears are exhausted.  This could take as short as 8 months or as long as 2 years.

The rest of the article goes a bit off the deep end especially regarding hyper inflation.  With a market drop off such as this deflation will be the result.  Wage demands are simply not there to support higher inflation.  Only until the 2020's when Boomer's exit the work force in large numbers but continue consuming [at a lesser rate] soaking up the excess labor.  This will move us to a labor shortage sparking inflation as wage demands will be rampant.  The 2020's will be mark by high inflation, high taxes, and a labor shortage.  The remaining portion of this decade will marked just the opposite with low taxes, low or possible deflation, and excess labor.

The biggest surprise will be valuations after the drop even at our maximum of 60%.  Stocks at that time will only be moderately undervalued not at the secular lows of under 10 using the Shiller PE10 model.  It will most likely take one more cycle to complete that task.  All told this could end up being a 20 year bear market as DYI marks the secular top in December 1999 at 44.20.

DYI    

U.S. Stock Market is Now Significantly above it's 15 Year Moving Average. Poor returns will Follow.

Yes, You Can Time The Market

DYI Comments:  Its a bird, no its a plane, no its a runaway overvalued, over bullish, stock market.

DYI  

Want to retire? Double your savings rate

That’s part of the message from the folks who organize America Saves Week — an annual opportunity for retirement savers, financial advisers and even the Social Security Administration to encourage people to assess their savings strategies. It’s not quite the Olympics, but it’s an event nonetheless. Give yourself a gold medal if you’ve amassed anything close to 10 times your final salary. If you haven’t — like most of us — get your trainers on and find new ways to save.

Well, saving 5% for 40 years whether it’s in a 2% or 4% real interest rate world may not help you accumulate a nest egg that will let you sustain your standard of living in retirement. In fact, you likely need to save at least 15% of your salary, which can include any match from your employer, according to Christine Fahlund a vice president and senior financial planner with T. Rowe Price. 

And the Employee Benefit Research Institute suggests that baby boomers in the lowest salary quartile would need to save 25% to achieve “retirement adequacy” 70% of the time, while generation Xers in the lowest income quartile would need to save about 16% to achieve retirement adequacy. 

DYI Comments:  Excellent article as Robert Powell of Market Watch comes up with the same numbers [as DYI] that is required to achieve the minimum for retirement.  As a standard policy I advocate every young person to accept the fact that every where they work to save 15% into their 401k.  Corporations that do automated enrollment is doing a great service for their employees.  However, most don't push the savings up to that 15% mark many end at 5% or 6%.

DYI