By: Tim Melvin, Benzinga
The subject of market direction and near-term price movements is discussed frequently in the media, and pretty much wherever investors gather to talk about stocks and bonds.
Most of us have an opinion and are delighted to share this carefully formed insight (read: wild-eyed guess) with anyone who will stop long enough to listen. It is discussed endlessly but it can be one of the least important conversations you can have. No one knows where the stock market is going to go in the short run — and picking precise turning points is a waste of time for most investors.
While we can spot markets that are overvalued or undervalued using measures like the Schiller PE Ratio and the Market Cap to GDP Ratio, it is impossible to tell exactly when markets will turn. Investors should use these measures as a yellow light when they start flashing overvalued levels.
Fortunately for investors, they can also show us when markets are deeply undervalued, and should provide high returns going forward. Of course it is important to understand they can stay at low levels for an extended period of time, but they ultimately should turn upward and eventually reach overvalued levels. Investors need to know that this low-to-high valuation move can take years, not the weeks or days most investors seem to favor.
Example: The U.S. Markets
If you look at the U.S. markets, the Market Cap to GDP Ratio was at undervalued levels throughout the 1980s and well into the 1990s — as GDP growth was robust and it was a great time to own stocks. In the late 1990s it started showing signs of overvaluation. Although to take several years before the market corrected after the initial overvalued readings history tells us that it was indeed a great time to be cautious with your money.
The measure was at bullish valuation levels all through the post-war years — until flashing danger signals in 1968 right before the disastrous sell-off of the early 1970s. The lowest readings since 1950 occurred after that meltdown, and although investors would have seen a great deal of volatility those who bought stocks then made enormous amounts of money over the next 20 years.
The Market Cap to GDP Ratio is a big picture tool for investors. When it is low, it is a great time to buy cheap stocks for the long term — and there will be plenty of cheap stocks with excellent financials and prospects. When it is high, investors should be much more selective about their purchases — and be judicious about selling holding that trade above their fair value.
Right now the U.S. markets are reaching the stage that can be defined as very overvalued. The Market Cap to GDP Ratio is currently at about 1.25. Although short of the peak level of 149 reached in the internet bubble, it is higher than it was in 2007, when the financial crisis hit and drove stocks lower by 50 percent or so. It can become even more overvalued but the caution lights are clearly lighted at this point in time.
Other Examples: Italy, Brazil
If we look globally, we can find some nations that are still clearly undervalued and may offer better long-term opportunities than domestic stocks right now. The lowest Market Cap to GDP Ratio in the world today is Italy. The ratio there stands at just 16 percent, as the Italian economy continues to struggle. Unemployment is at an all-time high and GDP growth has been negative for two years in a row.
The government just announced tax cuts and is taking other measures to get the nation’s economy turned around. We are also starting to see private equity firms like Blackstone (NYSE: BX [FREE Stock Trend Analysis]) acquire Italian assets, as they look to benefit from the turnaround. Patient investors could do very well with Italian shares over the next decade, if the government is successful in turning the economy around.
Brazil also makes the list of undervalued nations, with a Market Cap to GDP Ratio of just 43 percent. The country has been experiencing a combination of high inflation and weak economic activity that is reminiscent of the 1970s here in the US.
Brazilian President Dilma Rousseff is starting to lose the support of the populace, as her economic policies have pushed the once fast-growing economy into a lengthy slowdown. Bad news is now good news, as each new piece of poor economic news increases the chance that the next election will produce a more business friendly government and take measures to spur growth once again. The Brazilian economy is very heavily commodity-oriented, so any pickup in global growth rates will also be good for Brazilian equities.
The Market Cap to GDP Ratio is not a precise timing mechanism. If you try to use it to time short term trades you will almost certainly go broke in a rapid fashion.
However, it is very useful at helping identify markets where valuations are unsustainably low and may have the potential for very high long term returns.
© 2014 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.