“That ‘buffet indicator’ says the stock market will collapse.“ That was an email I received recently that deserves a more in-depth discussion. Let me start with my favorite line “The Prince’s Bride.”
“Not me think it means what you think it means.”
The Buffett indicator is a valuation measure that compares stock market capitalization to gross domestic product. A favorite of Warren Buffett, the indicator just under 2.44 times market cap of GDP. This figure alone doesn’t say much, but it is remarkable when placed in a historical context. Even after markets’ recent decline, the ratio is still one of the highest on record, north of the 2.11 level recorded during the dot-com bubble 2000and significantly increased compared to the average since 1950.
Since 2009, repeated monetary policy interventions and a zero interest rate policy have caused many investors to dismiss any action “Valuation.” The rationale is that the indicator is wrong as there was no direct correlation.
The problem is that valuation models are not and should never be “Market timing indicators.” The vast majority of analysts assume that this is a benchmark (P/E, P/S, P/B, etc.) reaches a certain level, it means that:
- The market is about to collapse, and;
- Investors should be 100% cash.
That’s wrong. Rating metrics are just that—a measure of current rating. More importantly, when valuations are inflated, it’s a better measure of that “Investor Psychology” and the manifestation of “The Greater Fool Theory”.
What valuations provide is a reasonable estimate of long-term investment returns. It’s logical that if you overpay today for a stream of future cash flows, your future rate of return will be low.
Why the Buffett indicator is valuable
Although often overlooked, the Buffett indicator tells us a lot while measuring “Market Cap” to “GDP.” To understand the relative importance of the measure, we need to understand the business cycle.
The premise is that in an economy that is about 70% consumption-driven, individuals must produce in order to have a paycheck to consume. It is from this consumption that companies derive their revenue and ultimately profits. If something happens that leads to less production, the whole cycle is reversed, leading to economic contraction.
The example is simple as many factors affect the economy and markets in the short run. However, economic growth and corporate profits have a long-term historical correlation. While it is possible for earnings to grow faster than the economy at times, ie post-recession, they cannot outpace the economy indefinitely.
Since 1947, earnings per share have grown 7.72% annually while the economy has grown 6.35% annually. Again, the close relationship of growth rates should be logical. This is especially true given the important role that expenditure plays in the GDP equation.
Therefore, the Buffett indicator tells us that overvaluation is unsustainable when stock market caps are growing faster than economic growth can support. Hence a market cap ratio (the price investors are willing to pay multiplied by the total number of shares outstanding) greater than 1.0 is overrated and below 1.0 is underrated. Today, investors pay almost 2.5 times what the economy can generate in terms of income and earnings.
Does this overvaluation mean the stock market will collapse? no
However, there are significant implications that investors should consider.
Valuations and Forward Returns
As always, the reviews are terrible “Market Timing” indicator, they are an excellent indicator of future returns. I previously quoted Cliff Asness specifically on this topic:
“Ten-Year Forward Average Yields fall almost monotonically as the starting Shiller P/E rises. Also, the worst cases get worse and the best cases get weaker as the starting Shiller P/E’s rise.
If today’s Shiller P/E is 22.2 and your long-term plan calls for a 10% nominal return (or around 7-8% in real terms given today’s inflation) on the stock market, They’re basically aiming for the absolute best case in history to be replayed, and aiming for something drastically above average for those ratings.
We can prove this by looking at 10-year total returns versus various historical price-to-earnings ratios.
“It [Shiller’s CAPE] has very limited utility for market timing (certainly alone) and there is still wide variation around his predictions over even decades. But if you don’t lower your expectations without good reason when Shiller P/E’s are high – and I don’t think the critics have given a valid reason this time – I think you’re making a mistake.”
And speaking of Mr. Buffett, let me remind you of one of Warren’s more insightful quotes:
“Price is what you pay, value is what you get.”
That “buffet indicator” confirms Mr Asness’ position. The chart below uses Wilshire 5000 market cap versus GDP and is calculated using quarterly data.
Not surprisingly, as with all other valuation measures, future return expectations over the next decade are significantly lower than they have been in the past.
Basics don’t matter until they do
In which “heat of the moment” Basics don’t matter. As mentioned, they are bad timing indicators.
In a market where dynamics drive participants “Fear of missing out (FOMO)”, Basics are superseded by emotional prejudices. This is the nature of market cycles and one of the most important ingredients needed to create the right environment for an eventual reversal.
Attention, I finally said.
As David Einhorn once said:
“The bulls explain that traditional valuation metrics no longer apply on certain stocks. The longs are confident that everyone else who owns these stocks understands the dynamics and won’t sell either. Because the owners are reluctant to sell the shares can only go upwards – seemingly to infinity and beyond. We’ve seen this before.
there was not a catalyst that we know of when the dot-com bubble burst in March 2000, and we have no particular catalyst in mind here. That said, the peak will be the peak, and it’s hard to predict when it will happen.”
Furthermore, as James Montier previously said:
“Current arguments for why things are different this time are disguised in the economics of secular stagnation and standard financial workhorses like the equity risk premia model. While these may lend an air of seriousness to these dangerous words, taking arguments at face value without considering the evidence seems to me at least one common connection to previous bubbles.“
Stocks are anything but cheap. Based on Buffett’s preferred valuation model and historical data, return expectations for the next decade are likely just as negative as they were for the decade after the late ’90s.
Investors would do well to remember the words of then-SEC Chairman Arthur Levitt. In a 1998 speech entitled “The numbers game” he explained:
“While the temptations are great and the pressures strong, illusions in numbers are just that – ephemeral and ultimately self-defeating.”
Regardless, there is a simple truth.
“The stock market is NOT the economy. But the economy reflects the very thing that supports higher asset prices: profits.”
No, the Buffett indicator doesn’t mean markets are definitely going to crash. However, there is a more than reasonable expectation of disappointment in future market returns.
Editor’s note: The summary bullet points for this article were selected by Seeking Alpha editors.