“Snapshots of what’s going on in the world of money”
By Ed Emerson
One constant question amongst investors and day traders alike concerns the value of different stock market indexes, and if markets like the UK’s FTSE 100 are undervalued or overvalued opportunities at any particular time.
The Daily Telegraph’s John Ficenec provides some perspective on the FTSE in terms of one of Warren Buffett’s favourite market metrics: Market capitalisation to Gross Domestic Product (GDP).
This measure offers up a quantitative view of how much people (investors) are paying for shares in a company listed on a particular stock exchange in relation to how that country’s economy is performing.
Now this indicator has far more potential value for longer-term investors than day traders to b sure, but there’s value in understanding the principles here when you’re looking at a particular country market.
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The theory behind GDP to Market Capitalisation is relatively simple: If a country’s underlying economy is deemed not to be performing well, and investors are paying too much for shares in this market, then the assumption is that the price of those shares will fall sooner or later in order to come back into line with the performance of the economy.
The bottom line here is that it merits consideration as a market measure because Warren Buffett rates this method. And it’s hard to argue with a man who’s been getting it right since Baby Boomers had acne.
The long and the short of the chart above is that the UK market is currently overvalued.
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And what that means is that we can assume (and that’s always a dangerous tactic if you’re only using one metric to make a decision) that the FTSE, as an index, is potentially positioned to fall over time.
Now let’s remember two things about this assumption:
1) GDP statistics are anything but reliable calculations, as preliminary figures have been known to be off the mark by up to 1.4%. That kind of change in either direction could make a country’s future look either bright or bleak very quickly. So always consider how much emphasis you’re putting on GDP and where this information is coming from.
2) In any given market and at any given time, approximately 20% of the stocks will be overvalued, 20% will be undervalued and 60% will be relatively fairly valued. Your objective is always to find that set of shares in the undervalued segment of the index, a much more valuable sue of your time than chasing country stats.
Consider the relative value of the FTSE as a marker. If the metrics are saying the market is overvalued or undervalued look to Price Earnings (P/E) to drill down into this assumption. P/E is simply what investors are willing to pay for shares as a multiple of earnings over the course of a year. Check how much a company is generating in profit over the course of a year, then check the price of the shares and do the math. The higher the P/E figure, the higher the growth investors are expecting, and the more they’re willing to pay for that.
If the UK stock market is trading near record valuations just now as the chart suggests, relatively speaking investors are paying a lot for what they are getting in the expectation that the share price and the market will go higher.
Anything over that 100% line suggest the market is overvalued. And though its not quite at Dotcom levels, it’s very close to 2007/08 levels. That doesn’t mean the apocalypse is nigh.
It’s simply another string to your bow to get a more complete picture and better spot investment opportunities.
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