Tuesday, February 7, 2012

Equity Valuation Based on GDP Growth 2.0

This is based on my post Equity Valuation Based on GDP Growth with a slight twist.

As I've outlined previously, over the long run equity valuation and earnings both grow at roughly the pace as nominal GDP. If earnings (for example) grew faster, then earnings would eventually become larger than the entire economy, which is not possible.

With that in mind, here goes...

The below chart shows:

This is an attempt to compare historical S&P 500 valuation (relative to the size of the US economy), relative to the current valuation level. For example... if the S&P 500 (blue) is below the nominal GDP line (yellow), then the S&P 500 was cheaper then (on this relative measure) than it is now. It also means when the lines cross, valuation levels were equal to today.

The relevance: The chart below shows the relative valuation for each year from 1929 through 2001 (in December 2011 terms), then shows the subsequent 10 year forward change in the S&P 500 (note this does not include dividends).

This chart shows that if this valuation metric can forecast the future (I am not saying it will, but it seems useful), then equity markets may be a decent buy here. At relative value zero (i.e. today's measure) the trend-line goes through 0% on the x-axis at roughly 7.5% annualized (before dividends).