The Dow Jones Industrial Average ("The Dow") and Gross Domestic Product ("GDP") are two of the most important metrics in the respective worlds of finance and economics. The day-to-day movements of the Dow and other stock market indices like the S&P 500 and the Nasdaq dominate financial news and commentary. On the other hand, the quarterly releases for GDP offer one of the broadest measurements of economic performance. Combined, they create a powerful indicator for market valuation.
The chart above was constructed by:
In terms of development, one could stop at step two and have similar results to the chart above. However, subtracting a moving average creates an intuitive benchmark when reading the calculated metric by denoting zero as a "fair value." So, if the indicator is above (below) zero, the market is over (under) valued compared with recent trends.
While the concept of over or under valuation is difficult to analyze for many reasons, the metric performs well in terms of its relationship to the upcoming ten years of returns. Based on statistical analysis, in general, if the indicator increases, the expected ten-year market return decreases and vice versa. So, while the absolute level of the indicator may not mean it's a good or bad time to invest, increasing trends don't bode well for future returns.
As the indicator would be expected to fall toward zero or below during a recession and given that it is at historically elevated levels, the implication is that the next downturn will bring with it significant stock market losses. While this would likely always be the case, the elevated levels mean post-recession returns could also be low and hinder a financial recovery. So, given its current level, this indicator will be one to keep a close watch on.