1) What’s the price of alternative options? Maybe a chicken sandwich or some chili?
2) How much am I getting for the price? Is this a ¾ pound angus hamburger or one of those flimsy soyburger things?
3) How much have I paid for a similar burger in the past?
If you know the answers to those 3 questions, you could probably give me a pretty good estimate of the price you would pay for a burger. If you don’t, well… you probably don’t have much of a clue!
Just like a hamburger buyer without the aid of these 3 bits of information, the stock investor without the aid of a few valuation metrics doesn’t have much of a chance.
Unfortunately, most investors don’t give much thought to what they would be willing to pay for a stock or for the market as a whole. They just sort of buy here and sell there because it “feels right” at the time.
Without any tools to value a company or the market, you’re going to make bad decisions. There is no other way around that fact. Fortunately, you don’t need any statistical models or fancy formulas to value the market.
Add the following tools to your arsenal and increase your chances for success:
1. Market Cap to GDP Ratio
Warren Buffett says this ratio is the “single best measurement of market valuation at any given time.” When the total market cap as a percentage of GDP is greater than 90%, stocks are generally overvalued. When the ratio is below 50% stocks are incredibly cheap. When the ratio is above 115%, stocks are getting frothy.
2. 10-Year U.S. Treasury Yields
The 10-year U.S. Treasury bond is considered to be a “risk free” investment asset. If you can get a “risk free” return of 10% by investing in 10-year U.S. government bonds, wouldn’t you be less likely to invest in stocks?
Think of it like the price of a chicken sandwich. When chicken sandwiches are cheap, less people buy hamburgers. When U.S. Treasury bonds are cheap (yielding more than 4.5%), less people are willing to buy stocks.
3. Earnings Yield
Which would you pay more for… a ½ pound burger or a 1 pound burger? All else being equal, you would pay more for the larger burger. The earnings yield tells us how much our current investment dollar is buying in terms of company earnings. When the yield is high (above 6-7%), we’re getting more bang for our buck.
Just knowing these three metrics can help you tremendously when valuing a stock or the market as a whole.
When the market is overvalued by these metrics, start paring back on your allocation to stocks. When the market is undervalued, start selling everything (bonds, clothes, cars, children…) to buy more stocks.
How to Beat the Investing Pros in 10 Minutes or Less…
The 10-Minute Portfolios use market valuation levels to determine how much of the portfolio should be allocated to stocks vs. bonds. Since 1976, 3 of the 4 portfolios have outperformed the S&P 500 despite significantly lower volatility. Follow along with the 10-Minute portfolios by subscribing to the free investment newsletter.