The stock market finished 2012 with double-digits returns. The drama in Washington seemed only to push the market higher, as evidenced by the rally again at the start of the new year. As investors are happier with the higher balances in their account, they should never forget the word ��ISK,��which is directly linked to the valuations of the assets they own. A higher current valuation always implies lower future returns. GuruFocus hosts three pages about market valuations. The first is the market valuation based on the ratio of total market cap over GDP; the second is the measurement of the U.S. market valuation based on the Shiller P/E. These pages are for the U.S. market. We have also created a new page for international markets. You can check it out here. All pages are updated at least daily. Monthly data is displayed for the international market.
Why Is This Important?
As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is ��robably the best single measure of where valuations stand at any given moment.��
Knowing the overall market valuation and the expected market returns will give investors a clearer head on where we stand for future market returns. When the overall market is expensive and positioned for poor returns, the overall market risk is high. It is important for investors to be aware of this and take consideration of it in their asset allocation and investing strategies.
Please keep in mind that the long-term valuations published here do not predict short-term market movement. But they have done a good job predicting the long-term market returns and risks.
Wise man Howard Marks also pointed out that investors should always know where we are with the market. Predicting the direction of the market is hard. But investors can always make educated decisions based on current conditions.
Why Did We Develop These Pages?
We developed these pages because of the lessons we learned over years of val! ue investing. From the market crashes in 2001 to 2002 and 2008 to 2009, we learned that value investors should also keep an eye on overall market valuation. Many times value investors tend to find cheaper stocks in any market. But a lot of times the stocks they found are just cheaper, instead of cheap. Keeping an eye on the overall market valuation will help us to focus on absolute value instead of relative value.
The indicators we develop focus on the long term. They will provide a more objective view on the market.
Ratio of Total Market Cap over GDP - Market Valuation and Implied Returns
The information about the market valuation and the implied return based on the ratio of the total market cap over GDP is updated daily. The total market cap as measured by Wilshire 5000 index is now 97.5% of the U.S. GDP. The stock market will barely return 4% a year in the coming years. As a comparison, 12 months ago, the ratio of total market cap over GDP was 87.4%; it was likely to return 5.7% a year from that level of valuation. The 13% gain of 2012 has reduced the future gains by about 1.7% a year.
For details, please go to the daily updated page. In general, the returns of investing in an individual stock or in the entire stock market are determined by these three factors:
1. Business Growth
If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.
If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over the long term, corporate earnings grow as fast as the economy itself.
2. Dividends
Dividends are an important portion of the inve! stment re! turn. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.
3. Change in the Market Valuation
Although the value of a business does not change overnight, its stock price often does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual businesses, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.
Putting all the three factors together, the return of an investment can be estimated by the following formula:
Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)
From the contributions we can get the predicted return of the market.
The Predicted and the Actual Stock Market Returns
This model has done a decent job in predicting the future market returns. You can see the predicted return and the actual return in the chart below.
The prediction from this approach is never an exact number. The return can be as high as 10% a year or as long as -2% a year, depending where the future market valuation will be. In general, investors need to be cautious when the expected return is low.
Shiller P/E - Market Valuation and Implied Returns
The GuruFocus Shiller P/E page indicates that the Shiller P/E Shiller P/E: 22.2. Shiller P/E is 34.5% higher than the historical mean of 16.5. Implied future annual return: 2.7%. As a comparison, the regular trailing twelve month P/E is 17, slightly higher than the historical mean of 16. That is also why the media pundits are saying that the market is cheap.
Twelve months ago, the Shiller P/E was 26.4, and the regular trailin! g twelve ! month P/E was around 14. The market did look cheap with the trailing twelve month P/E.
The Shiller P/E chart is shown below:
Over the last decade, the Shiller P/E indicated that the best time to buy stocks was March 2009. However, the regular P/E was at its highest level ever. The Shiller P/E, similar to the ratio of the total market cap over GDP, has proven to be a better indication of market valuations.
Overall, the current market valuation is more expensive than the most part of the last 130 years. It is cheaper than most of the time over the last 15 years.
To understand more, please go to GuruFocus' Shiller P/E page.
John Hussman�� Peak P/E:
John Hussman uses the peak P/E ratio to smooth out the distortion of the corporate profits caused by the fluctuations of the profit margins. The current market return projected by his model is around 4% a year.
In his commentary on Nov. 26, Overlooking Overvaluation, he used the historical valuation of price to revenues, book values, dividends and cyclically adjusted earnings, and concluded that the market is somewhere between 40% to 70% above pre-bubble valuation norms. With any of these long-term valuation ratios, the market seems positioned for returns of around 5%, as shown in the chart below:
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This agrees with the returns projected by the ratio of total market cap over GDP and Shiller P/E.
In all the three approaches discussed above, the fluctuations of profit margin are eliminated by using GDP, the average of trailing 10-year inflation-adjusted earnings, and peak P/E, revenue, or book value, etc. Therefore they arrive at similar conclusions: The market is overvalued, and it is likely to return only 2% to 4% a year in the future years.
Jeremy Grantham�� 7-Year Projection:
Jeremy Grantham�� firm GMO publishes a monthly seven-year market forecast. The latest seven-year forecast published by GMO is below:
Asset Class| Annual Real Return |
| US Large Cap | 0.2% |
| US Small Cap | -0.40% |
| US High Quality | 4.9% |
| International Large Cap | 4.4% |
| International Small Cap | 4.1% |
| Emerging Market | 6.2% |
| US Bonds | -1.4% |
| International Bonds | -1.60% |
| emerging Debt | 2% |
| Index Linked Bonds | -2.70% |
| Cash | 0.1% |
GMO expected U.S. large cap real return is 0.8%. This number agrees with what we find out with market/GDP ratio and Shiller P/E ratio. The U.S. high quality will have higher return. The return is expected to be 4.9% a year.
Insider Trends
As indicated by the three different approaches discussed above, the best buying opportunities over the last five years appeared when the projected returns were at their highest level from October 2008 to April 2009, when investors could expect 10% a year from the U.S. market.
If average investors missed this opportunity, corporate insiders such as CEOs, CFOs and directors did not. As a whole, they purchased their own company shares at more than double the normal rate from October 2008 to April 2009. Many of these purchases resulted in multi-bagger gains. This confirmed again the conclusions of earlier studies: The aggregated activities of insiders can serve as a good indicator for locating the market bottoms. Insiders as a whole are smart investors of their own companies. They tend to sell more when the market is high, and buy more when the market is low.
As of August, we observed more insider buying activities. This is the current insider trend for S&P 500 companies:
The latest trends of insider buying are updated daily at GuruFocus' Insider Trend page. Data is updated hourly on this page. The insider trends of different sectors are also displa! yed in th! is page. The latest insider buying peak is at this page: September of 2011, when the market was at recent lows.
Conclusion: The stock market is not cheap as measured by long-term valuation ratios. It is positioned for about 3% to 5% of annual returns for the next decade. By watching the overall market valuations and the insider buying trends investors will have a better understanding of the risk and the opportunities. The best time to buy is when the market valuation is low, and insiders are enthusiastic about their own company's stocks.
Investment Strategies at Different Market Levels
The Shiller P/E and the ratio of total market cap over GDP can serve as good guidance for investors in deciding their investment strategies at different market valuations. Historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high-quality business and strong balance sheets will provide better returns in this environment. When the market is cheap, beaten-down companies with strong balance sheets can provide outsized returns.
To summarize:
1. When the market is fair valued or overvalued, buy high-quality companies such as those in the Buffett-Munger Screener.
2. When the market is undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener. Buy a basket of them and be diversified.
3. If the market is way over valued, stay in cash. You may consider hedging or short.
5 Best Small Cap Stocks To Buy Right Now: China Metro-Rural Holdings Limited(CNR)
China Metro-Rural Holdings Limited, through its subsidiaries, primarily engages in the development and operation of agricultural logistics and trade centers in northeast China. It also involves in purchasing, processing, assembling, merchandising, and distributing pearls and jewelry products. The company markets its pearls and jewelry products to wholesale distributors and mass merchandisers in Europe, the United States, Hong Kong, and other parts of Asia. In addition, it develops, sells, and leases residential and commercial properties in Hong Kong and the People?s Republic of China. The company is based in Tsimshatsui, Hong Kong.
Advisors' Opinion: - [By Wyatt Research Staff]
The stock moved significantly higher in mid-January and traded in a fairly tight range ever since. However, that could change soon. China's agricultural exports to Japan will grow if radiation continues to seep into the food chain.
China exported $593 million worth of agricultural goods to Japan last year.
5 Best Small Cap Stocks To Buy Right Now: FuelCell Energy Inc.(FCEL)
FuelCell Energy, Inc., together with its subsidiaries, engages in the development, manufacturing, and sale of high temperature fuel cells for clean electric power generation primarily in South Korea, the United States, Germany, Canada, and Japan. The company offers proprietary carbonate Direct FuelCell Power Plants that electrochemically produce electricity from hydrocarbon fuels, such as natural gas and biogas. Its fuel cells operate on a range of hydrocarbon fuels, including natural gas, renewable biogas, propane, methanol, coal gas, and coal mine methane. The company also develops carbonate fuel cells, planar solid oxide fuel cell technology, and other fuel cell technologies. It provides its products to universities; manufacturers; mission critical institutions, such as correction facilities and government installations; hotels; and natural gas letdown stations, as well as to customers who use renewable biogas for fuel, including municipal water treatment facilities, br eweries, and food processors. The company was founded in 1969 and is headquartered in Danbury, Connecticut.
Advisors' Opinion: - [By Roberto Pedone]
Fuelcell Energy (FCEL) designs, manufactures, sells, installs and services ultra-clean, highly efficient stationary fuel cell power plants for distributed baseload power generation. This stock is trading up 7.2% to $1.01 in recent trading.
Today’s Range: $0.94-$1.01
52-Week Range: $0.83-$1.95
Volume: 1.27 million
Three-Month Average Volume: 1.04 million
From a technical perspective, FCEL is ripping higher here right above its 50-day moving average of 92 cents per share with above-average volume. This move is quickly pushing shares of FCEL within range of triggering a near-term breakout trade. That trade will hit if FCEL manages to take out its 200-day moving average at $1.05 and then once it takes out more overhead resistance at $1.06 with high volume.
Traders should now look for long-biased trades in FCEL as long as it’s trending above its 50-day at 92 cents per share, and then once it sustains a move or close above those breakout levels with volume that hits near or above 1.04 million shares. If that breakout hits soon, then FCEL will set up to re-test or possibly take out its next major overhead resistance level at $1.18. Any high-volume move above $1.18 will then put $1.39 into range for shares of FCEL.
- [By SmallCap Investor]
The developer of stationary fuel cells used by commercial and government customers might be headed for a rebound from a pullback that began this spring - which has left the stock down 39 percent year-to-date.
Sky-mobi Limited engages in the operation of a mobile application store in the People?s Republic of China. It works with handset companies to pre-install its Maopao mobile application store on handsets and with content developers to provide users with applications and content titles. The users of its Maopao store could browse, download, and purchase a range of applications and content, such as single-player games, mobile music, and books. The company?s Maopao store enables mobile applications and content to be downloaded and run on various mobile handsets with hardware and operating system configurations. It also operates a mobile social network community, the Maopao Community, where it offers localized mobile social games, as well as applications and content with social network functions to its registered members. The company owns proprietary mobile application technology in the cloud computing, the MRP format, and SDK development environment. As of March 31, 2011, it had entered into cooperation agreements with approximately 523 handset companies to pre-install Maopao. The company was formerly known as Profit Star Limited and changed its name to Sky-Mobi Limited in October 2010. Sky-mobi Limited was incorporated in 2007 and is headquartered in Hangzhou, China.
Advisors' Opinion: - [By Wyatt Research Staff]
MOBI hit another 52-week high of $12.15 late last week. The stock continues to surge on increasing volume. The latest advance in share price came after Oppenheimer upgraded the stock to "Outperform".
Last week, the China-based internet portal and gaming provider giant Sohu.com (Nasdaq: SOHU), announced an advertising agreement with MOBI.
5 Best Small Cap Stocks To Buy Right Now: Voyager Oil & Gas Inc.(VOG)
Voyager Oil & Gas, Inc. engages in the exploration and production of oil and gas in the United States. It primarily focuses on oil shale resource prospects in Montana, North Dakota, Colorado, and Wyoming. As of May 17, 2011, the company controlled approximately 141,500 net acres in the five primary prospect areas comprising 28,000 net acres targeting the Bakken/Three Forks in North Dakota and Montana; 14,200 net acres targeting the Niobrara formation in Colorado and Wyoming; 800 net acres targeting a Red River prospect in Montana; 33,500 net acres in a joint venture targeting the Heath Shale formation in Musselshell, Petroleum, Garfield, and Fergus counties of Montana; and 65,000 net acres in a joint venture in the Tiger Ridge gas field in Blaine, Hill, and Chouteau counties of Montana. It supplies energy and fuel for industrial, commercial, and individual consumers. The company is based in Billings, Montana.
Advisors' Opinion: - [By SmallCap Investor]
Shares of this explorer, which has operations in the Western U.S., crossed back above $3 and have risen 40 percent in the past month, amid increasing investor interest in companies drilling in the Bakken region.
5 Best Small Cap Stocks To Buy Right Now: Achillion Pharmaceuticals Inc.(ACHN)
Achillion Pharmaceuticals, Inc., a biopharmaceutical company, engages in the discovery, development, and commercialization of treatments for infectious diseases. The company focuses on the development of antivirals for the treatment of chronic hepatitis C; and the development of antibacterials for the treatment of resistant bacterial infections. Its drug candidates for the treatment of chronic HCV include ACH-1625, a protease inhibitor, which is in phase IIa clinical trial for the treatment of chronic HCV; ACH-2684, a pangenotypic protease inhibitor, which is in phase I clinical trial for the treatment of chronic HCV infection; and NS5A inhibitors for the treatment of chronic HCV infection, including ACH-2928, which is to enter a phase I clinical trial, as well as various additional NS5A inhibitors in preclinical development. Its pipeline of product candidates also includes ACH-702 and ACH-2881 for drug resistant bacterial infections; elvucitabine for HIV infection; and AC H-1095 for HCV infection. The company was founded in 1998 and is based in New Haven, Connecticut.
Advisors' Opinion: - [By Brian Nichols]
Achillion is an odd play because it has both the most upside and the most downside of any stock on this list. The company's developing and testing its hepatitis C treating drug, ACH-1625, which is currently in phase II. The results of initial testing have consisted of ups and downs, but after many years and a long process, ACH-1625, appears to be on the right track for an FDA approval.
The upside in shares of ACHN comes from two places: encouraging data from trials and its likelihood of being acquired. In my opinion, ACHN has a very high chance of being acquired in the next 6 months. Both Pharmasset (VRUS) and Inhibitex (INHX) were acquired over the last 5 months with insanely large premiums. VRUS was purchased at a 81% premium and INHX for a 182% premium. ACHN is perhaps the most speculative, but it could also be purchased the cheapest.
The stock's recently pulled back after a downgrade and is trading much lower over the last couple weeks. The stock's trend reminds me so much of INHX; the month following the VRUS acquisition when INHX traded higher by nearly 300%. But then after the one-month gain, INHX lost its momentum and traded lower by 40% before being acquired with a 182% premium. INHX traded higher after the VRUS purchase because investors thought it would also be acquired, because of its hepatitis C candidate. ACHN is following the same trend, from November 12 till January 13 the stock more than doubled, but has since retraced.
At $10 I think ACHN is a buy, it does have a good HCV candidate, and I believe that big pharma will bid to acquire ACHN in the near future. However, the risk in ACHN is if the company's not acquired, then it could have significant loss over the next year. But in a competitive biotechnology industry I believe the reward is worth the risk, and that a large pharma company will take the chance and purchase ACHN in an attempt to stay competitive and capitalize on the trend of investors being bullish on HCV treating drugs.
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