So far, 2022 has been a very tough year for investors. The S&P 500 is now down over 20% this year, and the Nasdaq Composite is even down an astonishing 28%. We are officially in bear market territory and investors are desperate to know when the slide finally ends and a bottom buying build. Of course, we do not have this crystal ball and predicting when this will happen is the hard to tell.
The stock market valuations are predictive of the future, not reflective of the present. Therefore we should have a look what is ahead of us.
The state of the economy and the stock market are strongly correlated. Over the long term the valuation of the broad stock market will reflect economic growth. Proof of this is the Buffett Indicator: the ratio of total U.S. stock market valuation (using the very broad Wilshire 5000 Index) to gross domestic product (GDP). For very good reasons, value investor Warren Buffett calls it “the best single measure of where valuations stand at any given moment.”
Right now, the overall fair market valuation should be about 125% of GDP but the ratio is currently around 175%, or 33% higher. Conclusion: either the GDP has to increase substantially or the market has to fall even more to get back in line with the long-term trend.
As the stock market valuations represent the value of expected future economic activity, so, what is it to be? Are we expecting a stagflation or recession and markets have to come down even further to match a historic average fair value again or do all the exciting innovative technologies that are just gaining traction push productivity growth up at an even a faster rate?
If latter is true, perhaps valuations are closer to fair value and the correction is closer to its end than we think.
Sven Franssen