One way to try to judge whether the stock market is cheap or expensive is to compare the valuation that investors are putting on companies with the output of the economy.

You can do this by comparing the total stock market capitalisation of a country with its Gross National Product ( GNP).

Stock market cap to GNP ratio = (Stock Market Cap / GNP) x 100

Where:

• Stock market capitalisation = The value of all the companies on a particular stock market.

• GNP / Gross National Product = The market value of all the products and services produced in one year by the labour and property of the residents of a country.

Unlike some technical indicators, this ratio makes logical sense to me.

Individual company earnings – or the earnings of entire sectors such mining or retail –  can be very volatile. That limits the value of using price to earnings ratios to spot bubbles – even if you smooth them by using a cyclical P/E.

However in a developed economy, it seems intuitive that the economic output of a country and the earnings of its companies – and hence their valuation – should bear some sort of relationship.

That’s where this ratio comes in.

Warren Buffett’s favourite ratio

The stock market / GNP ratio means nothing in and of itself – there’s no rule that the ratio should be X or Y at any point in time.

However by comparing today’s ratio with previous readings over time, we can potentially spot episodes of over- or under-valuation.

I say potentially because the ratio is not perfect, as I’ll explain below.

But it was good enough for Warren Buffett in 2001, who wrote:

The ratio has certain limitations in telling you what you need to know.

Still, it is probably the best single measure of where valuations stand at any given moment.

Buffett was using the measure to explain how he saw the Dotcom bubble developing the late 1990s.

The question is can we use the stock market to GNP ratio to spot new bubbles in advance?

Note on GNP versus GDP: Buffett compares the stock market to GNP. Most analysts use Gross Domestic Product (GDP) instead. In theory this should matter a lot. GDP is defined according to location, being the goods and services produced by a country. GNP is defined by ownership, as I’ve explained above. In practice though the two numbers are very close for the US, and the US is the only country where this ratio seems to be regularly computed. So like others, I use GNP and GDP interchangeably below.

History of the stock market to GNP ratio

When you look back in the history books, most stock market peaks in the US have coincided with an elevated level for the stock market to GNP (or GDP) ratio.

And that makes sense. Excessive profitability for companies tends to revert to the mean, and productivity improves slowly.

Advanced economies as a whole grow at low single digit rates, too.

This all means that big run ups in stock prices over short-periods tend to have more to do with investor sentiment than fundamental changes to the long-term prospects of those companies.

In other words, we’re by turns greedy and fearful. Sometimes we’re like footballers’ WAGs in Harvey Nicks, and no price is too high. At other times we’re haggling for cut-price bargains at a boot sale.

By looking at the ratio of stock market to economic output, you can try to spot the ‘greedy’ times and tailor your strategy accordingly.

For example this article and graph from Smart Money used the ratio to suggest that the US stock market had outgrown the US economy:

Smart Money noted that:

U.S. earnings are near a record high as a share of the economy. Over the past 80 or so years that has tended to mean that earnings are about to shrink.

Thus, the chart. If share prices are constrained by earnings, and if earnings are constrained by the size of the economy, investors might as well compare share prices with the economy directly.

Sounds sensible, but with the benefit of hindsight we can see two glaring problems:

• US company earnings didn’t shrink – they kept growing!

• The US stock market rose over 10% in the subsequent 12 months.

If you that graph prompted you to reduce your holdings of US equities and go to cash, you lost money.

Market timing is extraordinarily difficult, and this is just another reminder.

Problems and limitations with the ratio

Wary though I am of disagreeing with Warren Buffett, it seems to me this ratio is no more useful than most other ways of guesstimating whether shares are expensive or not.

It might give the determined active investor some clues, but it isn’t going to solve the mystery.

Let’s consider a few of the problems.

Little UK data for the stock market to GDP/GNP

It shouldn’t be hard to produce UK data, and no doubt various firms do on a private basis. But I can’t find public sources on the Web.

The ratio has only really been looked at in-depth for the US, which limits its usefulness for the rest of us.

Different countries have very different markets

I think it could be misleading to apply this ratio to other countries too superficially, anyway.

For example, one Seeking Alpha writer wondered in 2011 which stock market was the most expensive by this ratio, and produced the following graphic:

The author noted that:

There are several reasons determining the size of a country’s stock market capitalization including, for example, the equity-buying culture of the local population, company use of debt versus equity financing, the country’s regulatory and legal environment as well as how easy it is to list on the local exchange.

In general however, it is probably safe to assume that there should be a positive correlation between a country’s market capitalization and its GDP.

Indeed it turns out there is a very high, 0.96 correlation between the world’s largest economies GDPs and their stock market capitalisations.

I agree with the second paragraph, but I’d question the utility of the third.

The problem is the variations behind that average ratio are so wide. For instance, the author found that at the time of writing, the ratio for Italy was 0.3 and for Germany it was 0.43, whereas for the UK it was 1.5.

Did that mean that Italy or Germany was 4-5 times cheaper than the UK?

I don’t think so.

The UK stock market is home to many companies from around the world. We’re also one of the most capitalistic of the major economies. Our listed market is a bigger deal than the equivalent for Germany or Italy, which are home to far fewer foreign firms and where there are surely more companies in private or even State ownership.

You would need to look at a particular country’s ratio over the long-term to derive any useful insights into its market valuation versus economic output at any particular time.

And comparing one country’s ratio with another seems entirely spurious.

What about overseas sales?

This is an important factor, which most of the articles I’ve cited also mention.

Apple, Google, and many other big US companies earn much of their money overseas. This means that comparing their valuations with US economic output could be misleading. Why should they be limited by US growth?

Of course, global trade is nothing new. I don’t know off-hand how the proportion of earnings generated by US companies overseas has changed over the years.

I know it has changed, though, and it is another factor to consider.

The ratio is often elevated, and thus arguably useless

The biggie. Look at the graph from Smart Money again. The red line is mainly above the blue line, which means the US market has most often tended to look overvalued.

History may yet prove this to be the case, but over long multi-year periods it’s been a pretty poor signal to get out of stocks.

The ratio is even more stretched if you go back to the 1950s:

(Source: Vector Grader)

This is a really interesting graph, because it suggests the US market might have been very over-valued for a couple of decades.

I have previously explained why I think carefully looking at long-term returns suggests that ain’t necessarily so.

Which view is right? Who knows – history is unfolding before our eyes. My best guess is the answer lies somewhere in the middle.

Clearly the US market was a steal in the 1950s and 1960s (when Warren Buffett started getting rich, incidentally). This was when the ‘Cult of the Equity’ was born, and investors began to shift wholesale from bonds to equities.

However I think globalisation and various other factors have probably changed the ‘fair value’ level for the ratio since the 1950s.

In addition, with interest rates very low – and fears of inflation not abated – it is arguably rational for investors to pay more for the earnings of companies today.

You’ll have to make your own mind up. As always, I certainly wouldn’t use this ratio in isolation from other factors.

Remember, most methods of predicting the returns from equities have a truly dire track record. Be warned!

Between 1956 and 2011, the value premium has been worth an extra 3.5% in the UK1. That’s an annualised return – so that’s 3.5% on top of what you’d have wrung out of the FTSE All-Share, every year.

That’s the kind of come hither talk that pumps my assets, so I’ve scoured the fund universe for a way to get a piece of the action like a SETI telescope searching for intelligent life.

And lo, though I encountered plenty of slimy, betentacled hostiles, I’ve also made contact with more passive friendlies than I had previously believed possible.

The value premium for UK investors

We’ve discussed what the value premium can do for passive investors before. In this post, I’m going to survey the index funds and ETFs that UK investors can use to tap into it.

These funds invest in companies tattooed with the mark of value. Their equities are either undervalued or perceived to be riddled with risk. Either way their price is depressed enough that juicy returns can follow if fortune smiles.

By selecting these funds for our portfolio, we’re essentially hoisting our sail to capture those value winds. But we do so in the knowledge that the wind blows fitfully. There can be long periods where we trail the market because the winds don’t come.

Oh yeah, and before we go on, we need to admit that value investing is an active strategy.

Value funds have to decide on the rules that govern which firms they will choose to buy from the pick ‘n’ mix of all available equities. Inevitably these rules require more interpretation, compared to a tracker that simply scoops equities according to their market cap.

But that’s okay, passive investing isn’t an excuse to turn your brain off and it does often require more active decision-making than is routinely acknowledged.

Moreover, you can buy value funds from firms operating according to clear methodologies grounded in academic research – as opposed to financial Wizard of Oz characters proclaiming their preternatural ability to beat the market.

Now I’ve chased away the lily-livered with my torturous preamble, let’s get down to it. UK investors have four flavours of value fund to choose from (not counting hooking up with an international broker to access the myriad options in the US).

1. Dividend weighted funds

Equities that pay out high dividends in comparison to their price have value characteristics. However, a high dividend to price (D/P) ratio is the weakest form of value and has historically been outperformed by other measures such as book to price (often known as book-to-market).

It’s also worth considering that the price of equity income and dividend funds has jumped over the last few years, as bond yields have plummeted and income hungry investors have turned to equities.

That’s likely to lower the returns of dividend trackers in the future. All the same, they must be included in any UK survey of value funds.

2. Fundamental funds

Trackers that follow fundamental indices invest in the broad market (e.g. the FTSE All-Share) but don’t weight their components by the traditional method of market cap.2

Instead, fundamental trackers select equities according to health indicators such as profits, sales, and book value.

By investing in a fundamental tracker, you buy into a broad market fund with a stronger value signal than usual, without the issues of turnover and excessive concentration that can afflict other value approaches. The PowerShares FTSE RAFI ETF series is the brand champion in this arena.

3. Value factor funds

Value trackers follow an index of equities that rank highly for one or more value factors such as earnings to price, cashflow to price, price to book, and dividends to price.

This is similar to the fundamental approach except that the value tracker is ‘value concentrate’ as opposed to ‘value flavoured’. In other words, it comprises equities that represent the value subset of the market, rather than the entire market weighted in favour of equities with value tendencies.

Then there’s Dimensional Fund Advisors (DFA).

Dimensional are a fund shop who specialise in value. Their funds are extensively used by passive luminaries such as William Bernstein, Larry Swedroe, and Rick Ferri.

However, DFA funds are not index funds. They use a single factor – high book-to-market (price) – to select their equities, but they don’t follow an index.

This enables the firm to trade advantageously, keep costs low, and offer the widest range of value funds available in the UK.

Sadly, DFA funds are only available through approved financial advisors. Monevator specialises in DIY investing but, all the same, if you can find an advisor who’ll offer DFA funds for a reasonable fee then it’s an option worth considering.

4. Active funds

The advent of clean class options means that a few actively managed funds, with a value remit, are relatively affordable now that the commission price puffery has been stripped out.

You can use MorningStar’s style box to help you track down likely candidates, although I’ve only found two that I’d trust to stay on style.

A value fund hitlist for UK passive investors

Lordy, have I finally got to the point?

Here’s my selection organised by asset class:

Global Value Funds	Approach	Style3	OCF (%)4
Dimensional International Value Fund	Value factor	Large Value	0.57
PowerShares FTSE RAFI Dvlpd 1000 ETF	Fundamental	Large Value	0.5
PowerShares FTSE RAFI All-World 3000 ETF	Fundamental	Large Value	0.5
DBX Stoxx Global Select Dividend 100 ETF	Dividend	Large Value	0.5
Dimensional Global Targeted Value Fund	Value factor	Small Value	0.66
Dimensional Multi-Factor Equity Fund	Value factor	Mid Value	0.62

• Note: Global usually means developed world.
• Although the All-World fund does include emerging markets.
• Only the DFA International Value fund excludes the UK.
• The DFA Multi-Factor fund is a 100% equity fund of funds.

US Value Funds	Approach	Style	OCF (%)
UBS (Irl) ETF – MSCI USA Value I-dis	Value factor	Large Value	0.23
PowerShares FTSE RAFI US 1000 ETF	Fundamental	Large Value	0.39
SPDR S&P US Dividend Aristocrats ETF	Dividend	Large Value	0.35
Vanguard U.S. Fundamental Value Invr Inc	Active fund	Large Value	0.95

• Strange but true – Vanguard dabbles with active fund management. Here it has sub-contracted to a deep value specialist, Pzena Investment Management.

European Value Funds	Approach	Style	OCF (%)
Dimensional European Value Fund	Value factor	Large Value	0.57
PowerShares FTSE RAFI Europe ETF	Fundamental	Large Value	0.5
SPDR S&P Euro Dividend Aristocrats ETF	Dividend	Large Value	0.3
iShares EURO STOXX Ttl Mkt Value Large5	Value factor	Large Value	0.4
UBS-ETF MSCI EMU Value A	Value factor	Large Value	0.4

• You can roll your own international value allocation out of the US and European options.
• Completists can add the Pacific Rim and Japan. I haven’t checked these out.

UK Value Funds	Approach	Style	OCF (%)
Dimensional UK Value Fund	Value factor	Large Value	0.54
Dimensional UK Core Equity Fund	Value factor	Large Value	0.36
PowerShares FTSE RAFI UK 100 ETF	Fundamental	Large Value	0.5
Valu-Trac Munro UK Dividend Fund Class X	Dividend	Large Value	1.5
SPDR S&P UK Dividend Aristocrats ETF	Dividend	Large Value	0.3
Vanguard FTSE U.K. Equity Income Index	Dividend	Large Value	0.25
Aberforth UK Small Companies	Active fund	Small Value	0.85

• The DFA UK Core fund is a broad market fund that tilts towards value.
• The DFA Value fund specialises in value equities.
• The Munro fund is a dividend focussed fundamental fund. i.e. It doesn’t select equities according to their market cap. Recently acquired by Maven Capital.
• The Aberforth Smaller Companies fund has a near identical (but slightly cheaper) investment trust twin.

Emerging Markets Value Funds	Approach	Style	OCF (%)
Dimensional Emerging Markets Value Fund	Value factor	Large Value	0.72
PowerShares FTSE RAFI Emerging Mkts ETF6	Fundamental	Large Value	0.65
iShares DJ Emg Mkts Select Dividend ETF7	Dividend	Large Value	0.65
Dimensional Emerging Mkts Targeted Value8	Value factor	Mid Value	0.97

All table data researched in April 2013.

Remember, a fundamental tracker takes the place of a broad-based market cap fund in your portfolio, and adds a value accent to that asset class.

If you choose any other value approach then keep your core funds but split off a percentage of that asset’s allocation for the value fund.

Take a look at Tim Hale’s Global Style Tilts portfolio or look up William Bernstein’s Four Corner’s portfolio for portfolio ideas.

Also bear in mind that there is no strict definition of value investing. Research your own choices to ensure you understand how they work. Different approaches will bear different fruit and we have no way of forecasting which will prove to be the juiciest.

Perfection is academic

And now, for my final off-putting caveat: No value fund will capture the full value premium as defined by the academics.

That would involve going long value equities and shorting growth equities, which as passive investors we have no truck with, especially as we’d only use it to run over our own feet.

So think of your value fund like a sardine net. You’ll catch some of the shoal but not the whole lot. Some days (or years) you won’t catch anything, but when you do it will make for a nice, tasty lunch.

Take it steady,

The Accumulator

1. According to research by Dimensional Fund Advisors. [↩]
2. i.e. With the market cap method, if a company is worth 10% of the index then it makes up 10% of the tracker. [↩]
3. As per MorningStar classifications [↩]
4. Or TER. Learn more about the difference [↩]
5. Full name: iShares EURO STOXX Total Market Value Large ETF [↩]
6. Full name: PowerShares FTSE RAFI Emerging Markets ETF [↩]
7. Full name: iShares Dow Jones Emerging Markets Select Dividend ETF [↩]
8. Full name: Dimensional Emerging Markets Targeted Value Fund [↩]

Good reads from around the Web.

After typing my little fingers off last night with my thoughts on the response to the death of Margaret Thatcher, we’ll go straight to this week’s links today.

[continue reading…]