A Buffett Rule of Thumb

I recently read an article from Dan Ferris and he had some interesting statistics about the current valuation of the stock market.

From a contrarian point of view, excessive optimism and speculation produces excessive, dangerous valuations. If you were to measure the valuation of current market based upon price/earnings (P/E) ratios, dividend yields, and the ratio of the stock market to GDP. All three point to excessive valuation of the overwhelming majority of stocks.

The U.S. stock market is trading at around 18 times earnings. That means the average U.S. stock portfolio bought today might double your money in 18 years. Stocks are yielding about 1.85%. Dividends on a basket of U.S. stocks bought today will pay back your initial investment in 54 years.

He also uses on of Warren Buffett’s favorite indicators. The U.S.’s GDP is about $14.75 trillion. The Wilshire 5000 index contains about 98% of U.S. stocks by market cap. If you add the missing 2% to the Wilshire, the U.S. market is worth about $14.9 trillion.

So the U.S. stock market is now priced higher than the entire output of the U.S. economy. That’s like saying the entire U.S. economy consists of nothing but a few thousand publicly traded companies. Stocks aren’t truly undervalued until the market is around 80%-85% of GDP. At 100%-plus, they’re absurdly expensive.

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