Spoiler alert! I don’t know.
The Australian economy, as measured by gross domestic product (GDP), is forecast to contract 4% in 2020 according to The Australian Financial Review’s economist survey. Since the S&P/ASX 200 Index (ASX: XJO) peaked on 20 February, the share market is down 27%.
So how is the market being valued by investors?
Warren Buffett’s valuation method
One of Warren Buffett’s favourite stock market valuation methods, known as the ‘Buffett indicator’, is the total stock market capitalisation as a percentage of GDP. According to Gurufocus, the ratio of the Australian stock market (measured by the S&P/ASX 300) over GDP is currently 92.49%. This is compared to a historical average of 139% and indicates that the stock market represents reasonable value.
It is worth noting that the ASX 300 provides up to an additional 100 smaller-cap shares compared to the ASX 200. Economic data for the March quarter is also not yet available and would likely result in an increased percentage from a decline in GDP.
The US stock market
For some context, stocks in the US have seen a significant rebound from previous COVID-19 and oil price pessimism. This is despite a 4.8% annualised decline in US GDP during the March quarter, according to the Bureau of Economic Analysis. As a result, the ‘Buffett indicator’ for the Wilshire 5000 total market index is sitting at a record high of 179%. This compares to a 20 year average of 107%, according to the Federal Reserve Bank of St. Louis.
To get a more accurate picture when applying the ‘Buffett indicator’, we will need to wait for some more data from after COVID-19 began having an impact.
For GDP and other economic data, the markets will be keeping a keen eye on the RBA meeting tomorrow and release of an updated chart pack on Wednesday.
To get a true picture of the impact of the economic downturn on businesses and assess the relative values to the stock market, we will likely need to wait until Q4 results are released in July and August.
With so many companies suspending guidance, Q4 June results will be our first chance to see the full impact of COVID-19. Only part of the Q1 March results was impacted by the virus and government restrictions, so current share prices reflect forecasts at best.
Like any indicator, the ‘Buffett indicator’ isn’t perfect. One variable that can skew the results is the composition of the index and growth rates of the largest companies. If the largest companies are growing faster than historically, the market should pay a higher price for that growth. The FAANG stocks are an example of this in the US.
I believe picking individual shares based on their own fundamentals and dollar-cost averaging is a great strategy to minimise the impacts of short-term valuation risk.
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Motley Fool contributor Lloyd Prout has no position in any of the stocks mentioned and expresses his own opinions. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.