Measuring the Bubble

Measure what is measurable, and make measurable what is not so.
– Galileo

Last week, the U.S. equity market climbed to the steepest valuation level in history, based on the valuation measures most highly correlated with actual subsequent S&P 500 10-12 year total returns, across a century of market cycles. These measures include the S&P 500 price/revenue ratio, the Margin-Adjusted CAPE (our more reliable variant of Robert Shiller’s cyclically-adjusted P/E), and MarketCap/GVA – the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues – which is easily the most reliable valuation measure we’ve ever created or tested, among scores of alternatives.

A few charts will bring the valuation picture up-to-date. The first chart below shows the ratio of MarketCap/GVA, which now stands beyond even the 2000 market extreme.

Take MarketCap/GVA, put it on an inverted log scale (left) and you get the blue line below. The red line (right scale) is the average annual nominal total return of the S&P 500 over the subsequent 12-year period. The correlation between the two is 93%. From present levels of valuation, we fully expect the S&P 500 to lose value, on a total return basis, over the coming 12-year horizon. That’s not a worst-case scenario or an outcome that depends on unusual economic outcomes. It’s actually the standard, run-of-the-mill expectation given current valuation extremes, and it assumes substantial expansion in the U.S. economy over this horizon.