How Does the U.S. Economy Work? (An Accessible Overview for All)
How Does the U.S. Economy Work? (An Accessible Overview for All) Recently, a client asked me a great question: “Is there a book you can recommend...
3 min read
Chris McAlpin
:
Feb 22, 2024 4:35:04 PM
A client recently asked me this question, “What will stocks do this year?” In fact, a lot of people ask me this question this time of year. Heck, I don’t blame them. We all want to know the future (myself included), so we can prepare for it and (hopefully) profit from it. I’ve even tried to predict the future — at least when it comes to stocks.
Of course, we’re not the first to ask this age-old question. In ancient times, kings would descend from their thrones to visit seers to prepare for battle. Today, we look to market wizards to make S&P calls, or forecast as to what number the S&P 500 will close for the year.
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But the Bible warns us, “Now listen, you who say, ‘Today or tomorrow we will go to this or that city, spend a year there, carry on business and make money.’ Why, you do not even know what will happen tomorrow. What is your life? You are a mist that appears for a little while and then vanishes. Instead, you ought to say, “If it is the Lord’s will, we will live and do this or that.” James 4:13-15
But we can study the data.
Clint Sorenson, our lead investment strategist, recently wrote our 2024 Market Outlook. It is worth a read. In it, he points out that the S&P 500’s 150-year average return is 7% after inflation; which is probably an acceptable return for most investors, even if it doesn’t give you bragging rights.
However, the S&P 500 has experienced six major Bear markets losing more than 59%; which averages to one every twenty-five years or once a generation. I don’t know about you, but I suspect that a 59% loss would ruin most investor’s financial goals. A loss like that may destroy your financial plans.
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Averages do not predict the future, however, they merely tell us what happened in the past. There is another indicator that foreshadows future events — stock market valuations. The old adage, “buy low and sell high,” is one of the easiest said and yet hardest done sayings in history. How do you know when a price is low or when it is near its peak?
Well, you don’t know, but you can look at a valuation to determine how the price compares to historic norms. And by comparing to past value ranges, you should have a good idea of future long-term returns. I stress long-term returns because valuation models don’t tell the timing of gains and losses, just the likelihood.
Warren Buffett once said this was his favorite stock market valuation tool. Media and marketing experts grabbed that idea as if it was his only market valuation formula. It is certainly just one of many that Buffett and his team have used for decades, but the name stuck.
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Regardless, the Buffett Indicator is a relatively easy formula to understand. It compares the total U.S. stock market to the total U.S. economy by dividing the U.S. stock market value by U.S. GDP. In simple terms the U.S. stock market is the scoreboard for the U.S. economy, therefore they have a historical mathematical relationship.
A picture is worth a thousand words:
The Buffett Indicator (blue line) is at its second highest valuation in history. More importantly, it is 63% above its historical trend line (dotted line). Why does that matter? Great question! Why should we care – right?
Well, I regret to inform you that your high school math teacher was actually right — you will use algebra as a grown up, and this is one of those moments.
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As we can see from the chart above, the Buffett Indicator always returns to its historical trend line. The big point of this chart is that the U.S. stock market is overvalued when compared to the U.S. economy. And to keep this article at least moderately short, currently the Buffett Indicator is approximately 1.7 standard deviations above trend. The historical peaks are around two standard deviations above trend.
Total nerdom – I get it. But understanding this data is important.
Not necessarily, but crashes have historically happened from this space. There are a lot of people in the investment world who disagree with us. The leaders at Vanguard would probably disagree, at least the Bogleheads. However, GMO’s data supports what we are saying.
Our main point is that the Buffett Indicator and other data tell us that the risk-reward scenario for U.S. stocks is low and not attractive. And we believe there are other investments of which our clients should take advantage. Yes, we think high quality U.S. stock will continue to be a strong investment in the long-run. But we don’t currently think it is a good idea to chase growth stocks.
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So, what should you invest in? It depends on your goals. What are you trying to accomplish? If you want growth, pure growth — and you have years to handle the risk of a stock market crash — then pile into a diverse portfolio of all stocks. We are not recommending this portfolio, but if you can handle the risk, I suspect you will do well over time.
But if you want slow and steady growth or income to meet specific life goals in the future, then we need to build a portfolio to meet your lifestyle. As I have told our clients, “You have more options now that rates are higher than the last 10+ years.”
Money is just a tool. Let’s shape your portfolio to serve you.
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