Assessing Equities' Valuation Based on GDP

In order to determine market valuation level, I use a ratio between the S&P and GDP.  Working with quarterly data from 1990 to the present, I compute a ratio, assume it is log-normally distributed, and express it as a percentile, from 0 to 100.  My thinking is that this gets around the question of earnings, which are hard to estimate right now, and reflects the long term view that ownership of companies in the index reflects the value of a claim on a slice of the GDP.  While stocks may appear cheap on a P/E basis, trailing or forward, that has little meaning because of the lack of visibility.

To illustrate, here is a chart of recent S&P 500 prices, alongside some hypothetical readings on my S&P/GDP ratio (click to enlarge):

The way I interpret this, the S&P is now at a low equal to what it reached in 1990.  I was in business then, and not an investor.  But what I remember is that you could buy a house in Texas with a credit card, excessive commercial construction had littered the landscape with “see-through buildings,” and S&Ls were dropping like flies.

When I looked at this in May this year, I suggested S&P 1,100 as a reasonable bottom, comparable to the low point in 2002.  Because Greenspan intervened heavily to support the economy after 9/11, it seemed likely that the low that year was a good point of comparison for a probable low in 2008, given the heavy intervention by Bernanke and Paulson.  That thesis failed, perhaps because the fall of Lehman was a triggering event, or perhaps because the CDS, CDO, MBS, CMBS etc., alphabet soup is far more unstable than I expected. 

Applying similar thinking to individual stock prices, I have noticed that once a stock breaks down out of its normal range, it can just sink indefinitely, with no necessary correlation to fundamentals.  I hope this observation is not applicable to the S&P 500 as a whole, because the index is on the verge of detaching from its fundamentals, if it has not already done so. 

In any event, I don't think the market can get much lower and I plan to hold my existing positions.  For those more prudent than me, who may be on the sidelines with cash, I would suggest they may miss a sudden move upward if they stay out of the game much longer.   
 

Comments

[Steven Hansen:]

just a thought, maybe the problem is not that the stock prices are too low, but the gdp is too high. it will be interesting to see the level the gdp will fall to..

2008 Nov 24 03:54 AM