Tuesday, September 16, 2014

Indicators of Relative Value

Often investors fail to remember the important indicators of relative value in the market. Stocks fluctuate from being undervalued to overvalued. But the definition of these terms and the boundaries are subject to debate.

One important "indicator" is the aggregate value of the stock market vs. the total value of the Gross National Product of the the US economy.  When in the graph below, the blue line (Value of Stocks) is below the red (GDP) line,  stocks generally continue to rise. When the blue line rises above the red one, a correction usually follows not too long after.

Actually, the historical average for the ratio of equity value to GDP is around 70%. (When the blue line touches the red, the ratio is 100%. Just before the correction in 2001, the ratio reached 150%. Just before the crash of 2008, it reached 112%.  The ratio is now 126%.  It has been above 100% since the beginning of 2013.

Another clue provided by the above graph can be ascertained by studying the relative movement of the blue and red lines from the late 1960's to 1980 where the value of stocks did not "keep up" with gains in the economy.  What was the cause?    The answer: RISING INTEREST RATES.  

So not only are we in a "overpriced" market, we are also at a point where rising interest rates are likely.  

It would seem that the intelligent investor should be particularly careful to search for individual stocks (and sectors) that can be purchased at reasonable prices rather than trying to follow the market.

If you were lucky enough to retire in 1982, the stock market was significantly undervalued, and we were poised for a period of falling interest rates...in other words, the perfect environment for a rising stock market and extraordinary returns.  The situation today is almost the exact opposite of the environment in 1982. 

Until we see a correction, being overweight in short term fixed income seems to be the most prudent prescription.