Here is a long term view of a few ratios that may help to view current market valuations. I used the DJIA in order to get a longer time series. It’s not my preference as market capitalization is not accurately portrayed via the index but I still think these ratios have value.
So how is the current market valued? Bears can point to GDP to market capitalization (approximated by blue chart) and make a valid point that the current market is fully valued and approaching overvalued. Bulls can point to broad market P/E levels (approximated by green chart) and make a valid claim that stocks are undervalued.
To reconcile those two charts we can look at the third chart in red, profits to GDP. The current recovery from 2008 has been dramatically different than any previous recovery due to the explosive growth in corporate profits while employment growth, wage growth, and GDP have all been tepid. This growth in profits is the primary fuel for the strong market rally off the 2008 lows. Those looking at other traditional economic measures of the economy have been left surprised at this market move. But ultimately it is has been and will continue to be all about the corporate profits.
Profits to GDP are currently the highest level since at least 1947 (length of this data series available). Other reports with more data say the 1920’s. Is there limit to which corporate profits can reach as a percent of GDP? If so, what would be a catalyst for this ratio to move lower (GDP outpaces profit growth). A stronger dollar, energy profits collapsing, wage pressures? Or is possible profits remain at an elevated level to GDP.
Summary: Using market valuations to predict/determine market turning points is largely a waste of time as overvalued stocks can become more overvalued and the same with undervalued. The period from 1955-1965 is great example of stocks remaining highly valued relative to GDP and the period of 1975-1985 is a great example of the opposite. One thing becomes clear looking at these charts. Profit to GDP is at unprecedented levels. The reason why is likely a combination of multiple factors, however, whether this trend continues, levels out, or declines will likely be the most important factor to stock prices over the next couple years.
So how is the current market valued? Bears can point to GDP to market capitalization (approximated by blue chart) and make a valid point that the current market is fully valued and approaching overvalued. Bulls can point to broad market P/E levels (approximated by green chart) and make a valid claim that stocks are undervalued.
To reconcile those two charts we can look at the third chart in red, profits to GDP. The current recovery from 2008 has been dramatically different than any previous recovery due to the explosive growth in corporate profits while employment growth, wage growth, and GDP have all been tepid. This growth in profits is the primary fuel for the strong market rally off the 2008 lows. Those looking at other traditional economic measures of the economy have been left surprised at this market move. But ultimately it is has been and will continue to be all about the corporate profits.
Profits to GDP are currently the highest level since at least 1947 (length of this data series available). Other reports with more data say the 1920’s. Is there limit to which corporate profits can reach as a percent of GDP? If so, what would be a catalyst for this ratio to move lower (GDP outpaces profit growth). A stronger dollar, energy profits collapsing, wage pressures? Or is possible profits remain at an elevated level to GDP.
Summary: Using market valuations to predict/determine market turning points is largely a waste of time as overvalued stocks can become more overvalued and the same with undervalued. The period from 1955-1965 is great example of stocks remaining highly valued relative to GDP and the period of 1975-1985 is a great example of the opposite. One thing becomes clear looking at these charts. Profit to GDP is at unprecedented levels. The reason why is likely a combination of multiple factors, however, whether this trend continues, levels out, or declines will likely be the most important factor to stock prices over the next couple years.