Profiting From Share Overvaluations

Today we look at sharemarket valuations as predictors of future earnings courtesy of an article by The Daily Reckoning’s Vern Gowdie.  Late last year we presented a number of different measures of how overvalued the US sharemarket appears to be at the moment.  In an article yesterday Gowdie presented the following graph which shows the 4 most common long term valuation method measures indicating that only 2 times before in history has the market been more over valued than it is now:

However arguably we are currently in unchartered territory in terms of the shear amount of debt in the system (an all time record high of 325% debt to GDP globally) and the effect that has on the system over the longer term.  Economist Stephen Jones has developed the DAME method which does exactly that.  Taking data back to 1962 compared to the other more generally accepted valuations, DAME was easily the most accurate forecaster of the next 10 years, with a 90% correlation compared to the others averaging around the hight 40%’s.  Graphically it looks like this:

As you can see from above, his model (as at June 2015) is by far the worst forecast for the next 10 years at an average return of MINUS 9.39%.  10 years is a good long term investment horizon (the standard advice is take a 7-10 year investment horizon for any decision).  So to be buying the S&P500 now you could expect on average to lose 9.4% of your money.  The S&P sneezes and our sharemarket catches the same cold.

Alternatively gold, an historically uncorrelated asset, in that time could be expected to have healthy gains as the shares fall.  More specifically, over 10 years the reality to achieve that -9.4% average would be, say, a 50% drop on a sharemarket crash and only a partial recovery within that period.  What might be a prudent strategy would be going overweight gold/silver now, profit-take on the sharemarket crash gold rally, and then deploy into those (then) cheap shares. Win win.