Economists have a way of coming up with more ratios and statistics than you can shake a stick at. True to my profession, I have developed a long-term yardstick of market overvaluation and undervaluation. I have no short-hand for it yet so I’ll call it what it is: 10-yr. rolling average S&P 500 annualized returns vs. annualized nominal GDP growth. Now, that’s a mouthful. Let me explain what it’s supposed to show.
Basically, the stock market is a reflection of the inherent earnings capacity of the economy. As the economy grows, so do market earnings. As a result, one would expect the returns in the stock market to reflect the growth in the economy — at least over the long term i.e., 10 years. Unfortunately, that’s not how it works.
In the real world, stock markets become severely overvalued or extremely depressed depending on whether its a bear or a bull market. The reason is P/E ratios. During bull markets, they rise. In bear markets, they fall. And, as a result, the stock market simply does not reflect the underlying growth in the economy and earnings capacity of business — even over the long term.
That’s where my graph comes in. If the economy and the stock market grew at the same rate, one would see a relatively mild fluctuation in the comparison between the 10-year average returns in the market and in nominal GDP. Now, look at this chart.
That’s not what this chart shows at all. Comparing the S&P 500 index of the leading U.S. companies to the economy shows violent swings. In the last bull market, the differential was over 10%! That’s enormously overvalued. In the 1970s it was a differential of over -10%. That’s a severe undervaluation. Today, we have moved back into line — annualized returns on the S&P since 1998 are about the same as nominal GDP growth over that span.
This chart proves that market timing is crucial. Buying into an overvalued market can be deadly. But catching it at its nadir is sweet.