Way back in 2008 I posted about a chart I made of the All Ords Index vs the Australian GDP price index series, which appeared to be a good warning sign of when the market was 'irrationally exuberant' and when it was 'oversold'. ie. When you might think about 'taking profits' and getting out of the stock market, and when the market was 'on sale' and a good buying opportunity. Of course, as Moom pointed out at the time, there are reasons why the stock market may increase relative to GDP, such as the decades long decline in interest rates (which made higher stock p/e multiples sensible - from 8-12x in the 80s and 90s to 15x-20x today). However, in the 'long term' it seems rational for the stock market as a whole to increase in line with GDP. So when the 'irrationality of crowds' makes the market oversold or overbought, one has better than normal chance of actually benefiting from trying to 'time the market' (I generally buy and hold, as timing attempts generally increase transaction costs more than performance, and I tend to buy index funds or ETFs rather than trying to 'pick' individual stocks or sector funds).
So, with the recent market drop and recovery during the first half of 2020, I thought I'd get some updated data on the AllOrds Index (the ASX200 Index follows the same basic pattern) and the Australian GDP Price index series, and see how the plot looks today. As you can see below, this plot is still pretty good at showing when the market is relatively 'expensive' (too high) and when it is probably 'cheap' (too low). But, as DS1 pointed out, if you sold out of the market when it goes 5% or 10% above the 'expected' level, and bough back in once it dropped 5% or 10% below the expected level, you would have missed the large market gains of 1986-87 and 2005-2007. So, you'd probably want to take these levels as warning bells, rather than simplistic buy/sell signals. Possible it would be useful to combine tracking 30 vs 90 day moving averages with this simple 'too high'/'too low' market indicator to decide when a long-term investor should consider reducing and increasing their exposure to the stock market. That would help with making the decision to buy into the market when it is oversold, as it is usually quite hard to 'pull the trigger' and invest/reinvest when the market has dropped a lot - like in Mar 2008 or March 2020. Seeing that the market may have 'turned around' (rather than just a 'relief rally' during a bear market run), helps identify if the 'bottom' has passed.
If anyone is interested in tracking this relationship for themselves, quarterly GDP Price Index data and Monthly adjusted close All Ords Index data was obtained from the following free resources:
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