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Is the Australian market overvalued?

When we talk about value, we have to compare price to what we get. Yet, how do you value the stock market as a whole? One market metric is to compare the total market capitalisation of the stock market — the sum of all shares multiplied by their share price — and the Gross Domestic Product (GDP) of a country. Basically, the price of everything for the value of everything produced, in a rough way.

Market1

Source: GuruFocus.com

Above is the chart for the US stock market and US GDP. The two values aren’t 100% correlated, but a connection can be seen by the ratio of total market capitalization over GDP.  Warren Buffett, Chairman and CEO of Berkshire Hathaway (NYSE: BRK.A) has said this ratio is one of the best indicators of when the US stock market is overbought or relatively cheap to buy into. When the cost of something expands past the value, that becomes a bubble. A value investor wants to buy when good companies are being discounted, and this ratio helps gauge how much of a frothy bubble may exist, or it reveals when “you can buy a dollar for 70 cents”.

The chart below shows us that in 2009 it was down to about 60%, 2003 about 70%. These times would have been the best times to buy stocks, but if we remember, they were also the scariest times because no one knew where the market would stop falling to.It doesn’t tell you which stocks to buy, so you still have to do your research like usual, but with that much fear and dread in the air, people are just wanting to sell out to avoid further loss.

Market2

Source: GuruFocus.com

Now the foolish investor steps in. All the labourious reading and analyzing they did up until then told them which are the best companies to own, and now it is time to wade in, and pick them for 20%,30% or even 50% of their real value. This is when the phrase “Be greedy when people are fearful, and be fearful when people are greedy” is so true.

Where does Australia stand now?

The ASX website shows in June 2013 the domestic equity market capitalisation was about $1.347 trillion and the 2012 estimated GDP was $1.542 trillion (indexmundi.com), so the ratio would be $1.347 trillion/$1.542 trillion = 0.873.

The Australian Bureau of Statistics estimated that GDP has grown by 2.5% over the 12 months to Mar 2013, so the GDP may now be about $1.58 trillion, making our ratio about 0.852.

Month All Ords Price Index S&P/ASX 200 Price Index Dom. Equity Mkt cap $m
Jun-13 4775.4 4802.6 1,347,186
May-13  4914.0  4926.6  1,384,908
Apr-13 5168.6 5191.2  1,457,764
Mar-13 4979.9 4966.5  1,420,586
Feb-13 5120.4 5104.0  1,442,008
Jan-13 4901.0 4878.8 1,382,611

What does it mean? It is indicates the comparative value of the stock market is oversold, and 0.852 could be interpreted as 85.2% of the value of the GDP.  The chart below covers this ratio since the late ‘80s, showing that the ASX became 100% around 2002, and peaked at around 150% around 2007. You would have made money had you invested in 2002, but a bubble was forming and popped when the GFC struck. The time to buy again would have been 2009 when it was down to 60%.

MARKET CAPITALIZATION OF LISTED COMPANIES (% OF GDP) IN AUSTRALIA

Market4 Source: tradingeconomics.com

Foolish takeaway

The ASX is not overbought right now, but the US ratio is at 110% — fair valued plus a little. It’s time for Australian value investors to make a shopping list for the market of stocks before the sale ends. The cheapest times are usually the scariest, most uncertain times.

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any of the companies mentioned in this article.

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