Black Friday Stock Market Sale — 70% Off

December 2, 2008

With all the hoopla surrounding the bountiful bargains awaiting consumers at a time when retailers are dropping like …well, like stocks…let’s check up on one of our favorite stock bargain-o-meters: the correlation between GDP and stock market capitalization.

Mutual fund flows are one of the primary indicators that tell us when and where to invest in our MAXadvisor Powerfund Portfolios.This current bear market demonstrates why popular investing ideas don’t belong in your portfolio – the investments most popular with fund investors have been the hardest hit. Fund investors have been pulling tens of billions of dollars out of their stock funds each week. We haven't seen selling at these levels since the 2002 bear market bottom, so we expect current stock prices to be good buys for longer-term investors. However, after seeing the market sliced in half, investors may be looking for a bit more guidance on when to own stocks. Call it a second opinion.

One of our favorite methods of divining stock values involves the correlation between broad stock values and the economy in general. Since the S&P peaked over 1500 in early 2000, we’ve often noted the relationship between total stock market cap and the GDP.

At the beginning of 2008, we mentioned this correlation in our analysis of the Chinese stock bubble:

“Somewhere along the way, the total market cap of Chinese stocks exceeded the GDP of the Chinese economy – usually a bad sign, particularly for riskier stock markets and economies with fewer publicly traded companies.”

That’s one bubble now well into "pop" mode.

At first blush, you might not see a reason to relate U.S. stocks to the GDP, since there are other "sound" valuation methodologies based on fundamental indicators, including price-to-earnings ratios, dividend yields, and the like. 

The trouble with "fundamentals" (as many value fund managers are now finding out the hard way) is this: earnings and dividends can exist in a bubble and cause as much portfolio mayhem as buying a tech stock with a 100 P/E ratio back in 2000 would have.

Keep in mind that although many banks and homebuilders never saw their P/E ratios rise above 20, and delivered nice dividends during the recent real estate boom. In a real estate bubble, the amount of money a company makes writing mortgages or building homes is essentially irrelevant; in "normal" times, companies (the ones that can handle the slowdown) may never even approach peak earnings. For all practical purposes, many financial services companies and homebuilders had 40 P/E ratios simply because their earnings were overheated by 100% or more.

This bubble earnings theorem is one reason so many experts were calling stocks cheap all the way down, down, down this vicious bear market. Isn't there a better way?

The GDP is a measure of economic output in the U.S. The U.S. economy is such an engine of growth that it's fairly rare for the GDP to decline for a couple of quarters in a row – a phenomenon that's generally associated with a recession (current recession aside). Broadly speaking, the publicly-traded companies are responsible for the bulk of the GDP output. The total value of these firms is equal to their combined market capitalization – essentially what it would cost to buy them all.

(Sure, there are many small businesses that are not publicly-traded, but even those companies use products made by publicly-traded companies.)

Given this relationship, you can generally expect stocks to be more valuable if the economy grows.

Admittedly, there's no perfect relationship between what stocks should be worth relative to the economy, since the amount those companies can earn from the economy may vary. Right now, retailers will have great difficulty collectively earning in an environment rife with both competition and inventory as consumers slow their spending habits. But as a rule of thumb, stock bargains are available when the total market cap is less than the GDP, and pricey when it's more. 

Barron’s – a financial publication with a variety of insightful market coverage that often leaves you thinking the Dow is worth somewhere between 3,000 and 30,000, depending on whose analysis you believe – had a nice graphic highlighting this long-term relationship:

This simple chart speaks volumes. One thing that jumps off the page is how ridiculous stock valuations were in 1929 and 1999 – two very bad years to enter the stock market. We tend to believe stocks were cheap through most of the century – two major and one minor bubbles aside – which is the main reason (combined with a strong, growing economy) that stocks have performed so well in the past (with recent history being the obvious exception). 

Note that today's stocks are almost back down to their lowest levels since 1930. 

While this graph seems to demonstrate the ultimate get-rich-slow timing system, a word of caution: A depression can cause GDP to fall as much as 25% (however unlikely) which, coupled with the panic that such an economic decline would cause among investors, could move stocks down as much as 50% from current levels (ouch) as we transition from a "low" stock market capitalization vs. the GDP to an even lower one.

Of course, the same risk applies to our system of using fund flows. Perhaps fund investors will pull out $500 billion from mutual funds in some sort of uber-panic. This would undoubtedly cause an even greater bargain in stocks, but a bargain perhaps 25-50% below levels we already find attractive based on fund outflows.

This additional downside risk is worth taking, especially compared to the much greater downside risk when stocks are popular and expensive. 

Perhaps the most fascinating feature of Barron's GDP to stocks graphic is how much cheaper stocks are today than they were at the peak of the 2000 bubble – a valuation level we probably won’t witness for another 50 years (who knows, the bubbles have been appearing more frequently these days…). The GDP has grown since 2000, and stocks have dropped, so we're about 70% cheaper than we were when stocks were trading at around 200% of GDP. 

The current GDP is $14.4 trillion, while the current market value of stocks as of December 1st, 2008 is approximately $9.6 trillion, or 66% of total market cap. The market low, reached on November 21st, had us at around 60% of GDP - not the lowest level in history, but a lot closer to the bottom than the top.

So what does this mean for our Powerfund Portfolios? If we fall further, we plan to get out of our short funds and cut back on bond funds. The ultra-short ETFs held in our more aggressive portfolios have had some amazing spikes up on down market days. We believe the market may be close enough to the bottom to cut back on these shorts. In addition, U.S. 10-year Treasury bond yields dipped below 2.7% on December 1st – an almost absurd yield, and below the S&P 500 dividend yield. We may cut back further on higher-quality bond funds. Many professional investors noted how overpriced Treasury bonds are all year, only to watch as the bonds continued to get more expensive (yields lower, prices higher), making Treasury bonds the best investment of the year (except for short funds).