General ThoughtsOverall Stock MarketPortfolio Management

The Market Hit an All Time High, So Now What?

Happy Easter! I’m spending time at the North Carolina coast with my wife this weekend. We’re waiting for family to arrive from out of town, and we’re currently spending some time relaxing and reading. I got some good reading in yesterday and came across this excellent article by Toby Carlisle at Greenbackd about the state of the overall market and thought I’d share thoughts…

Focus on Stocks, not Markets

I don’t usually pay a significant amount of attention to where the market indices are trading at or what the valuation of the overall market is. I do track this data, and I always have an idea of whether the overall market is cheap, fairly valued, or expensive, but I don’t spend a lot of time thinking (worrying) about it. It’s much simpler to search for undervalued stocks, buy them with a margin of safety, and wait for them to appreciate to fair value. In fact, one signal that the market is becoming overvalued is when it’s hard to find cheap stocks.

The other reason I don’t pay much attention to the overall market (at least on a daily basis), is that valuations in the overall markets change slowly. I check overall market data once per month for about 20 minutes, as I do like to have a general idea of median P/E ratios, P/B ratios, dividend yields, profit margins, and a few other general metrics. But I do this just to stay informed on basic data, not to derive portfolio management decisions or to anticipate near term market movements. A quick glance once a month is all I need to stay in tune with this information.

What’s Next for the Market? 

But having said all this, it’s hard not to notice the overall market lately, as CNBC, Fox, and even local news broadcasts are talking about how the S&P 500 and the Dow are hitting all time highs. So what’s next for the market? I have no idea. I am hoping for a drop, so that some of the stocks on my watchlist become more attractive. But the market doesn’t care about my preference. I will say that I think despite the 140% rise we’ve seen in the last 4 years, I don’t think the market is dramatically overvalued, as some have suggested.

I don’t like predictions, and I’ll never make short term predictions, but I’ll venture a wild guess about the next decade. Returns over the next 10 years are likely to be around the historical average, or maybe slightly less. My guess is the S&P 500 averages somewhere between 6-8% annually over the next 10 years including dividends (4-6% annual appreciation). We of course are striving for much higher returns, and so we must be opportunistic and search for extreme value, with the number one goal (and number two goal) of always protecting against permanent loss of capital.

Luckily, we don’t have to rely on guesses about the market to make money, but rather the ability to seek and invest in undervalued stocks.

Buffett’s Favorite Market Valuation Metric

Here is a chart of Warren Buffett’s favorite measurement to judge the overall market value. The St. Louis Fed supplies this data: I’ll summarize it by saying the US GNP is the blue line, and the red line represents the value of the total US stock market (Total market cap around $16 trillion). (Note, the Fed’s numbers are slightly more complicated regarding the market cap, but it is sufficient to assume the red line approximates the total value of US stocks):

Buffett Ratio

As you can see, the great bull market of the 80’s and 90’s started from significantly lower levels (total market cap well below GNP). At the current time, if you use Buffett’s logic that stock values should roughly equal the GNP over time, then at the moment we are fairly valued.

I think that the market is maybe slightly overvalued relative to earnings and assets, but this doesn’t mean that there aren’t opportunities to buy cheap stocks. At most times, unless you have a very large capital base, it’s possible to find cheap stocks that have a built in margin of safety. Sometimes it’s easy, sometimes it’s hard, but there are usually enough opportunities. Walter Schloss made 21% annual returns from 1955-2002 and was fully invested nearly 100% of the time.

I’m not suggesting that you need to be fully invested at all times, but I do suggest to not worry about the overall market, and focus on searching for value. It’s a much more management (and realistic) task, and much more enjoyable. I’ll get into some screens I’m looking at in the next few days.

Later this week, I’ll be discussing more details on where we are with the market along with some screens I’m looking at currently to find value. Have a Happy Easter!

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