A market bloated like an elephant?
Following an action-packed week in investment markets, I would like to quote a few l i nes f rom John Godfrey Saxe’s famous 19th- century poem, “The Blind Men and the Elephant”.
IT STARTS WITH: earnings (P/E) ratios may appear to be high, we have to consider the S& P500 Index’s current P/E of 20.8 is relatively low compared to the 20-year average of 27 between 1990 and 2010. Of course, many parts of this ‘elephant’ can be singled out to support claims about why the elephant isn’t anything like an elephant at all. SO WHAT IS THE RIGHT ANSWER? HOW DO I GO ABOUT SEEING THE BIG PICTURE WITHOUT CONSULTING A CRYSTAL BALL? In my opinion, Warren Buffett provided us with t he perfect tool when he described the total market capitalisation relative to the total GDP as “probably t he best si ngle measure of where valuations stand at any given moment”.
As wit h a ny ot her r at i o a nd i n v e s t ment tool, t h e ma r k e t capitalisation-to-GDP ratio is based on historical data and should not be seen as a prediction of future performance. However, it may be t he best tool to determine whether this is a real elephant, because it involves looking at the total value of share prices relative to the monetary value of all goods and services delivered within a given country’s borders. It is the complete picture.
This ratio can only be determined on a quarterly basis ( because GDP f igures are only calculated quarterly) and it provides a view of what really happened in the economy in the last 12 months. Be warned, however, that this ratio should not be used for short-term recommendations.
When we take a look back, we see that total capitalisation passed GDP three times in the last three decades. The instances in both 1997 and 2007 were not only followed by volatile and stormy market conditions, but also showed up in our local share market, followed by no growth in shares for more than two years.
So what exactly makes the third t i me so different? This r at i o has been at more than 1 for the past t wo years. The short answer is that due to the US Federal Reserve’s generous interest rate policy, prices have been pushed up artificially to a large extent, leaving things at ‘ bubbling’ levels. My question is, what will happen when this policy changes?
Whether wrong or r i ght, t hose ‘elephant touchers’ are convinced we are f inding ourselves at high market levels worldwide, so ensure your portfolio is free of any overweight positions.