Sunday, December 22, 2013

Just the Facts Ma'am: Is the United States in a Bubble? Does the United States Look Identical to Japan Right Now?

Publish Date:  12-22-2013

The question of where the market will go "next year" is always a question... and it has various answers. This year in particular, though, there are concerns surrounding a stock bubble, and given the 2002 and 2008 bubble pops, that's scary.

I will discuss and demonstrate:

1. A widely focused on metric to measure the bubble theory.

2. Show how similarly GNP and GDP track.

3. Give 20 and 10 year historical data on this metric and demonstrate that those two periods look quite different using data from the Board of the Federal Reserve and the US Bureau of Economic Analysis.

4. Illustrate that the S&P 500 had it's best year in 16 years in 2013.

5. Show you that Japan and the United States look nearly identical right now.

6. The stock market (S&P 500) has been up 25% or more 10 times since 1970 (excluding 2013).  In eight out of those ten years the market showed a positive return the year after.

A Step Back: What Does the S&P 500 Return Look Like This Year

Below I have included an ordered scatter plot of the annual returns of the S&P 500 since 1980.

Updated January 2014

This is note focuses on the notion of a bubble, with arguments for and against, but drilling down on one metric in particular: Total Market Cap / GDP (or GNP)

Why This Metric?
Basically, because Warren  Buffet says so.

Here is a snippet from The Motley Fool:

In two separate interviews in 1999 and 2001 Buffett explained to Fortune magazine's Carol Loomis that determining whether the market is expensive or cheap doesn't have to be complicated. The metric Buffett uses is:

The market value of all publicly traded securities as a percentage of the country's business -- that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

Basically, Buffett divides the total market capitalization of the U.S. stock market by gross national product, or GNP -- not to be confused with gross domestic product, or GDP.

So how do you tell if the stock market is expensive? Buffett went on to explain: "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire."

Source: Warren Buffett's Favorite Market Indicator Shows the Stock Market Is Overvalued, written by Dan Dzombak.

Does This Metric Work?
Eh, kind of... From that same article comes this image (below) comparing the S&P 500 performance to Market Cap / GNP since 1995:

Provided by TheMotleyFool

I see them acting as coincidental indicators -- neither predicts the other, rather they move together. Obviously the S&P 500 is at an all-time high. The Market Cap / GNP is nearing highs reached in the last bubble (2007).  But I'll present data that shows something a bit different...

Why People Look at GDP
While Buffet  makes a point to specify GNP rather than GDP, a quick chart shows the two really don't differ that much.  I have included a chart from gurufocus with a time series of GDP and GNP, below.


So GDP trails GNP a bit as of right now.

Answering the Question
OK, here we go.

Data again provided by the Federal Reserve Bank of St. Louis for the last 20 years (the top is interpolated monthly, the bottom is quarterly).

Market Cap / GDP

Note that the median is 0.65 and the current level is 1.22.  But this chart all of a sudden looks very different when we squeeze it to ten years rather than twenty.  Checkout the same chart over 10-years, below.

Now we see where the fear is setting in (ignore 2002 and this is unchartered territory).  The first scatter chart way at the top of this post shows us that the S&P 500 so far has had its third largest gain in the last 34 years and this most recent chart illustrates that the Market Cap/ GDP measure is at its 10-year high.  Uh oh...

Mitigating Data
There is mitigating data, believe or not... It somehow gets left out of this argument often times.  This is a ratio, and if the denominator gets bigger (GDP), that ratio gets smaller.

Is there any reason to believe that GDP will grow faster than expected?  How about this article released today (Sunday 12-22-2013):

IMF Will Raise Forecast for U.S. Economy

WASHINGTON--The International Monetary Fund is raising its forecast for U.S. economic growth after Congress struck a budget deal and the Federal Reserve said it would begin to pull back on its signature bond-buying program, the fund's top official said Sunday.

"We see a lot more certainty for 2014," IMF Managing Director Christine Lagarde said on NBC's "Meet the Press." "So all of that gives us a much stronger outlook for 2014, which brings us to raising our forecast."

Ms. Lagarde did not immediately offer a new number in saying the IMF would raise its forecast. In October it said U.S. gross domestic product, the broadest measure of economic output, is expected to expand 2.5% in 2014.

U.S. GDP grew at its fastest pace in two years during the third quarter, increasing a revised 4.1%, and the unemployment rate has dropped to 7%, according to recent government reports.

Source: The Wall St. Journal written by Jeffrey Sparshott IMF Will Raise Forecast for U.S. Economy

Well now...

Even further, we know that US unemployment is not at the long-term goal for the FED (it's 7.0% right now and the goal is 5.5% (I think)).  So, that means there's room for expansion, as the IMF writes.  Hypothetically stock prices could rise, but that ratio of Market Cap / GDP could drop.

Want more mitigating factors?  
How about this incredible tidbit:

The stock market has been up 25% or more 10 times since 1970 (including 2013).
In order from best to worst the years were:
1995, 1975, 1997,  2013, 1989, 1998, 2003, 1985, 1991, 1980, 2009

The return of the S&P 500 the year after those huge gains was positive eight out of ten years (we don't know abut 2014 yet) (1981 and 1990 were negative years).

I have included S&P 500 returns from 1970 onward -- the 25%+ years are highlighted in green.

Source: Wikipedia

There does not seem to be any great force majeure for the market going down. Now, that doesn't mean it won't go down, but the rising tide of GDP (per the IMF) and the low cost of employment for firms with so many qualified applicants per job opening is at least some mitigating data that indicates, bubble or not, this market is not an obvious short.

Final Words
For those of you that follow me, you know that I have had my eye on Japan for a while.  That market is exploding.

Here's why I watch Japan so closely:

Check out this chart from the BUSINESS INSIDER:

What does it mean?... Playing loose and fast, it basically reads that The US and Japan are nearly identical in their Market Cap / GDP deviation from the the 10-year average. And what do you know... there's that number again... 10-years...

If you feel that Japan is a bubble, did you now the US looks just like Japan for this metric?

I didn't. But I do now.

Please note, this is in no way advice or a recommendation. I'm pointing out facts. NO TRADES.

This is trade analysis, not a recommendation.

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