Is The Market Expensive?


Mother's Little Helper portfolio was UP today +$71.41 (0.07%).

Overall GAIN YTD: +$3,122.21 (+3.12%).

Our benchmark index, the S&P 500 is UP +2.91%

http://money.cnn.com/data/markets/sandp/

"The big money is not in the buying and the selling....but in the waiting"

- Charlie Munger

I made my buys for the year on December 28, 2018, see the new portfolio here (Click Here).

Is The Market Expensive?

I've been looking at an interesting measure of market valuation. The ratio of Gross Domestic Product to the total value of the stock market. The idea is that the value of the stock market should be fairly inline with the value of everything we make. If 100% is inline then anything above 100% is getting expensive and anything below 100% would indicate that stocks are cheap.

There are some quirks and 'It Depends' issues with this measure because the price you pay for a stock should represent the future value investors are placing on that company, not today's value. The other problem with this method of valuation is that you have to ask yourself, "Compared to what"? If the ratio indicates that the market is expensive or overvalued, what are we comparing this to? The answer has to be bonds; or at the very least, other investment opportunities that have the ability to pay you more with the same or less risk.

What's The Ratio?

If we look at the ratio of the total stock market compared to GDP we find that we're sitting right about 143%. Don't freak out, I still contend the market is not expensive. The total stock market has a market capitalization of about $28.543 trillion and the U.S. GDP (latest figures) is about $19.500 trillion. When we start approaching 200% I'd say it's time to get nervous. If we're below at say the 80-90% levels then the market has a lot of room to run. But all this is depended on interest rates and the bond market. With interest rates as low as they are and the 10-year bond still hovering well below 3.00% it sure looks like we have a lot of room to let this bull market run before we have to worry, like maybe another 30%-40% before a big correction shows up. (143 + 40% = 200ish)

The Safety of Bonds

Today the 10-year treasury closed at 2.55%, in case you haven't been following along, that's an increase. Every time bond yields go up you have a decision to make, do you invest in bonds paying a higher rate with no risk, or stocks. That depends, do stocks pay you more, if so can you find stocks that pay you a higher rate and do it with the same or only slightly more risk.

Let's look at an example. 5 years ago the U.S 10-Year Treasury was paying 1.89%. Great let's buy those and lock in a 1.89% guaranteed return for the next 10 years.

However; AT&T stock was trading at about $36 and today it trades at about $37.50, that's only a $1.50 per share increase, not really any volatility in AT&T. In fact AT&T has a BETA of just 0.51, it's 50% less volatile than the overall market. Wow, boring you say. That $1.50 increase is an increase you never would have received from a bond. A bond pays you your principle and the interest, that's it, there's no appreciation. That $1.50 happens to be an appreciation of more than 4%. Looked at another way, the AT&T stock helped your money keep pace with inflation. Plus over those 5 years you would have received a 5%-5.25% dividend, every quarter in cash or additional shares. You might call AT&T a bond market equivalent. AT&T paid you 5% vs. 1.89%, that's amazing!

But wait, there's more. Most investors don't buy U.S Treasuries directly, they buy bond funds. The largest bond fund by assets under management is the iShares 7-10 Year Treasury Bond ETF, ticker symbol (IEF). When buying bonds your first assumption might be that bonds have no risk, they should be market neutral or safer than the stock market. Turns out this isn't true. If you had bought shares of the IEF 5 years ago you would have paid $107.16 per share. Today those same shares closed at $104.60, you lost money. However you were in it for the yield from those bonds and for the safety. The IEF has a yield of just 1.82% and an expense ration of 0.15%. You bought a bond fund and it under performed the U.S 10 year treasury! Seriously? Why is this the biggest long-term bond fund on the market?

Bonds Have BETA?

Did you know that bonds, at least in the way most investors buy them through funds have a BETA factor. That's that measurement of how risky an investment is compared to the overall market. That bond fund I'm using in the example above comes with a BETA that is over 3.5; that's more than 3 times the risk than if you had just bought an S&P 500 index fund.

But wait, there's more. You also didn't keep pace with inflation, so you lost money on the shares, you got a lower interest rate, and you didn't keep pace with inflation. This is the risk associated with bonds. Don't get me wrong, bonds can be a great investment and are a great tool for preserving wealth, but there are some myths out there about how safe bonds are and those myths can cost you a lot of money. What you buy, how much you pay, the yield and the duration are all really important. When interest rates are rising (like now) bonds are a tough place to be. But maybe some shorter duration bonds have a place in your portfolio. Be sure to do the homework.

Anytime you're making an investment always ask those basic questions; Is this the best thing I can do with this money? What other options do I have? Show me the numbers and explain it in plain language that anyone can understand. Creating wealth doesn't happen over night. The biggest gains come from slow methodical improvements over long periods of time.

For a moment, nothing happened. Then, after a second or so, nothing continued to happen.― Douglas Adams, The Hitchhiker's Guide to the Galaxy

As Always

Stay Invested

Clay Baker

Disclosure: I am personally invested long in some or all of these funds that appear in the Mother's Little Helper portfolio or manage these investments for my Mother's portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the MLH portfolio. Since I may on occasion discuss BitCoin and other cryto currencies I disclose here that I personlly own investments in the cryto currencies listed here: VTI, VWO, VEA, VIG, XLE, MUB, Bitcoin, LiteCoin

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or to be interpreted as providing a personal recommendation.

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This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice.
This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.

© 2016 by Clay Baker all rights reserved