Saturday, February 28, 2015

Where Market Valuation Is At Right Now?

In the past few years, we have probably given ourselves a little more slack because of the continuing bull run which does not seemingly going to stop. This bull run has been going for almost the past 6 years since the Great Financial Crisis and it has attracted many retail investors to start investing.




I was once a newbie investor so I totally understand how they were feeling. When market seems to be in buoyant mood and the counters you have in your watchlist are mostly green, you get a sense of security that investing is safe and profitable and you think the worst it could happen if the market undergoes some correction is to hold on to the stock and ride the storm for a couple of years. This is somewhat true in some sense. For example, buying ST Engineering at a PER of 20x means that it will take the company 20 years for them to replicate the earnings to break even at the current price you as an investor paid today. Assuming a 75% dividend payout, it will take you about 26.66 years of dividends collected to cover for the price you paid earlier. The same can be said with companies like SMRT which are trading at 30x. The logic may sound pretty decent, but I'm not too sure if we want to wait for that long to recoup our initial investment.

Company's valuation (regardless of whatever metrics you are using) remain the most solid fundamentals every investor need to consider before purchasing. I will not be talking about this for today's post. Rather, I will be presenting a very broad general market valuation of where we are at right now. Again, I want to emphasize that this is coming from a very high level point of view, so it may or may not affect your decision about today's market condition. For myself, I do not generally focus too much on these macro stories but it'll be good to understand them at the very broad level.

Here, I will be showing you the current overall market conditions based on 3 different metrics:


1.) Market Capitalization to GDP (Buffett Valuation Indicator)

If you have been reading the news regularly, this shouldn't be a stranger to you.

The market cap to GDP ratio, also dubbed the Buffett valuation indicator, is a long term ratio used to determine whether an overall market conditions is undervalued or overvalued. As the ratio suggests, a result that is greater than 100% is known to be overvalued while a value below 100% is know to be undervalued. 

If you think about it, this makes particular sense because anything above 100% means that market value has grown faster than the rise in earnings, which is a sign of overvaluation. As an investor, we certainly do not want to invest in such companies using the same logic.

In case you are wondering where we are currently at right now, we are at the 123% at the start of the year. It's probably around the same now until the next quarterly earnings are announced. A quick look at the past history and you can see that the indicator was at the highest at 153% during the dotcom bubble and 117% during the Great Financial Crisis. This gives us some indication of where we are at right now.



2.) Q Ratio (developed by Nobel Laureate James Tobin)

I have talked about this indicator at some of my posts in the past and Jeremy Grantham mentioned this a couple of times too.

The Q Ratio is an indicator of the total market value divided by the replacement cost of the overall market. This is a little bit like measuring the Price to Book where the earlier was like the Price to Earnings. Again, anything above 100% represents overvaluation while anything below represents undervaluation.

The current market we are at right now represents a Q ratio of 1.11, which indicates overvaluation. You can see for yourself where the Q ratio is at during periods where market crashed and you probably get the idea.




3.) Regression to Trend

If you have taken a statistics class in your college or uni days, you should know what a regression slope generally does to the mean of a pattern or trend.

The regression trendline drawn through clarifies the secular pattern of a variance from the trend. Where the market is trending above the regression slope, they are known to be overvaluation while the converse is true.

The periods during the dotcom bubble sees an unprecedented 147% overshooting to the slope. The same goes during the GFC where it shoots up 130%. Today's current market conditions are not too far from the peak during the dotcom bubble, which may be something an investor would want to consider.



Final Thoughts

Back to where we first start, I mentioned about the importance of focusing on the fundamentals of the company where as an investor we try not to overpay for what it is worth for. I think that should stand solid and one that every investors need to keep a close tap on.

The overall market conditions shown above is just a general guide, but it gives you an overall indication where the horse is at right now. If we apply the same logic to what we apply to individual companies, we would certainly want to avoid investing in the current market conditions. The fear of missing out on any further gains might be a loss of opportunity cost to you, but a potential permanent loss of capital might be an even more important to note of.

If you think that you are unable to participate in the current market conditions because most of the companies you researched are overvalued, then stand by the principle and put them in your watchlist. The day will come where opportunities will present itself to you so much that you might not even have the resources to take on. However, if you insist that you are ignoring valuations and you are investing for the sake of long term, then let me remind you that you might face a permanent loss of capital should things does not work out well for you. Even if it does, it might take a lot of granny years for you to recoup your losses, less alone make profits from it.

Revisit your principles in investing, focus on the fundamentals of the company and stay alert on what is going on the macro-economic news. You'll do fine just like that.


What do you think? Does the above makes any sense to you or do you have different thoughts?


12 comments:

  1. Hi B,

    You can say all you like, but some things are meant to be experienced. Some people would still be the last one standing when the music stops, some people would still be holding the hot potato and some people would still be hurt when the market crashes.

    I even think it's important to go near death without dying, so that you can be stronger in the future. Without experiencing portfolio failure, I think it's just pushing the inevitable to the future, probably riskier time.

    Just saying ;)

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    1. Hi LP

      I agree and get what you are saying.

      A failure can become a strength if they are used reasonably. But for every hundred of investors who undergoes such a drastic crash, probably only one bounce back stronger and the rest of the 99 disappears from the face of the investment earth.

      I have not personally gone through a drastic crash myself but I am trying hard to learn from people mistakes in the past and ensure I do not make the same that they did once (or more). I think it's good and prudent that we remind one another where the risks are on and off to ensure that we dont fall off drastically from the face of the earth though a failure fan indeed become a source of strength. If possible, id rather avoid it (not completely though) than exposing myself to those risks and bounce back later.

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    2. Hi B,

      You pretty remind me of myself when I was slightly younger. On the topic of mistakes, I remembered I once chatted to my bro in law who is an entrepreneur. In my whole life then, I am an extremely careful guy and rarely make mistakes, let alone big ones. I was confident, and will like to think that I am pretty capable I would say. Like you, I also tell him I prefer to learn from others mistakes than me making them. So confidently I told myself inside that I am different. He kept quiet.

      It makes sense to mitigate risk. But maybe what LP means, is no matter how careful you are, it is impossible to be mistakes free. Unless your life is just a straight line graph, as routine as it can be called boring when we looked back.

      Overall, it's better to both learn from other people mistakes and our own one. Learning from our own mistakes had greater impact, but make sure you can recover and not a big mistake. Most importantly is to "admit" and be back stronger! Most pple prefer to evade! I am sure you belongs to the former.

      just my thoughts!

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    3. Hi Rolf

      Thanks for sharing.

      Sure sure I get what you mean. Its quite.impossible to attain a completely straight line constant or upwards in life when we are facing an unpredictable journey ahead. I have made some grave mistakes in my life outside of investing and have learnt much from the experience so I understand what you mean.

      I think this article is more catered towards the other extreme end who did not even attempt to try to think about it. I was also once in their position so I hope this could give them a little.bit of thinking for the weekends :)

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  2. Hello B

    Just as im reading the book now. Of BW's investing principals. He can be holding on to cash for few years and wait for the opportuny to by his stocks when the price are undervalued. What ur posting here, i guess everyone know what may be coming. And its good we build up our cash before it gets crowned as king when that day come.

    Jfree

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    1. Hi Jfree

      Yes I am not advocating that crash might come soon but I just want to increase awareness to provide a balance view to those who see it.

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  3. Hi B,

    A good read, I have the following question as I read the chart:

    1) it's all based on US Market, right?

    Although there is definitely a positive correlation with US markets, would u be able to do a test with STI? As the US MARKET cheong, singapore market lags in terms of %

    Also, if we take the above "valuation" line and look at the years in stay above valuation, it is scarily long for most pockets for all 3 graphs.

    Of course, not asking anyone to all in.

    Only I siao, but I constantly thinking of stepping out too.

    Just my 2 cents thought

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    1. Hi B,

      I have the same thoughts of you regarding the US markets overvaluation, but I think that SI has raised a valid point regarding the relationship between the SG market and US markets.

      Based on P/E and P/B ratio that I track, the SG market seems very fair valued. However, I am also in the camp that the fallout of the US markets will hit SG shores and rock our boats when it eventually happens.

      We should be prepared that a hit in the US markets might cause a temporary capital loss in our local equity holdings as the contagion spreads. But I think that as long as we have solid reasoning why our current local holdings will be winners in the long run, we can keep holding on to them. The best case scenario will be tuning out the weak market sentiment and focus on the (hopefully same) dividend payouts of the companies we hold.

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    2. Hi SI

      I think GMGH has provided some answers that you need here :)

      We can roughly approximatr using the main sti constituent counters to see if those price to earnings and price to book seems overvalued. We can probably take the jardines banks and telcos to compute them.

      I am trying to wait until the market goes a little more crazier before selling some of my other stocks which I wanted to dispose of. I hv a few counters on my watchlist too so I am hoping I get those opportunity to add them soon :)

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    3. Hi GMGH

      Agree sti is mainly driven by global news so the US market is probably a good indicator of where the sti is going to go these days. Lets not keep guessing and see where the market takes us. Either way we gotta be prepared and more prepared.

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  4. This is some fantastic analysis B, and very interesting indicators for where the market is right now.

    As you know, I just sold off some stocks to pay off my investment loan, which I'm even more comfortable with now after seeing your analysis. I've also been hearing about more and more people taking out margin loans lately, which is a less technical but still good indicator that risks might be starting to mount in the market.

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    1. Hi Jason

      Good to see you killing and clearing off your leverage there. I'm sure it works better all around for you without the use of emotional leverage.

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