In last month’s issue, I covered the CAPE Ratio.

This time, we will look at the Buffett Indicator, which is a very similar tool. However, there are some differences between them, which make it worthwhile to look at both of them.

The stock market capitalization-to-GDP ratio is simply a ratio of the total stock market value divided by the Gross Domestic Product (GDP). Since Warren Buffet was the first who popularly proposed this metric in 2001, it is often termed as the “Buffet Indicator”.

The reasoning behind it is, that the total stock market valuation should generally tend to display a good representation of the underlying economy.

Waren Buffet referred to the ratio as “the best single measure of where valuations stand at any given moment”.

If the valuation is way higher than the total output that the economy can produce, then this might be a good indication of the stock market being overpriced.

In reverse, a comparatively low valuation might indicate that the actual performance of companies exceeds their valuation and would therefore suggest that the stocks are cheap.

It is a bit similar to looking at the price-to-sales (P/S) ratio of individual companies.

Historical Analysis of the Buffett Indicator

In the United States, the indicator is generally calculated by taking the Wilshire 5000 index as an approximation for the total stock market and dividing it by the current GDP number, which is published by the Bureau of Economic Analysis on a quarterly basis.

Looking at quarterly data starting from April 1971, we see that the indicator has been below 1 for most of the time. In other words, for the majority of the time, the GDP was higher than the total stock market valuation. Previous to 2013, the only times that the indicator was above one, happened throughout the Dotcom bubble and for a short period around the 2008 Financial Crisis. Since the indicator crossed the 1-mark in early 2013, it saw a massive increase over the following years. It actually topped out at 1.99 in December 2021, before dropping back down to 1.55.

The moving average over this time frame is currently at 0.83.

Under the assumptions that: a) the fundamental underlying framework hasn’t changed over time, and b) that the indicator should tend to revert to its mean, we would need to conclude that the stock market is still significantly overvalued.

The total US stock market value is currently close to 40 trillion. Reverting all the way down to its mean, would mean a stock market decline of 47%, resulting in a total stock market valuation of about 22.2 billion. Almost $18 billion of wealth would disappear.

Critical Assessment

There are some critical points, about the validity of this indicator:

• The Wilshire 5000 only includes companies, which are publicly traded. The GDP on the other hand is generated by public and private companies. Hence, shifts in the corporate composition will not be accounted for by the indicator and an increase in the percentage of public companies might push the ratio higher, even if the GDP stays flat.
• Through globalization, companies can grow internationally. For instance, American companies have increasingly sold products and services abroad, which might increase the valuation of the company without contributing to the US GDP (if they are not exported, but locally sold).
• Furthermore, there are also increased possibilities and vehicles for foreign investors, to invest in the American stock market. A lot of international investors might for various reasons be attracted to invest in American stocks.
• The last and probably most crucial point is the interest rate. Interest rates have been falling since the early 80s and have been close to zero for over a decade. The valuation of stocks are based on their future cash flows which have to be discounted by a discount rate. This discount rate, in turn, mainly depends on the cost of capital, i.e. the interest rate.
  • Moreover, the low interest rates also diverts investors away from low-coupon bonds, into more risky investments like stocks.

Buffett himself has a good description:

“These [Interest rates] act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”

— Warren Buffett

All of these critical points might offer an explanation for the general uptrend of the stock market capitalization-to-GDP ratio.

The Historical Trend Line Approach

An approach to account for that, is to measure the ratio against a historical trend-line, instead of an overall average.

Currentmarketvaluation.com has a nice chart for it:

The black line shows the “Historical Trend Line”, which is an exponential regression line, displaying the historic growth rate. Based on this rate and the fluctuations, the standard deviation lines can be deduced. One standard deviation means, that based on historic observation, the ratio was 68% of the time within these bands. The two standard deviation lines encompass 95% of the observations.

In the chart we can see that currently the indicator has recently dropped back below the +1 standard deviation line.

Under the assumption that the assessment of this model is viable and we are currently exactly at the +1 standard deviation line, the Likelihood of the stock market further declining is 84%.

The current Historical Trend Line would suggest a ratio of 1.29. This is much higher than the moving average of 0.83, as analyzed above.

Thus, instead of a 47% decline, the Wilshire 5000 would need to decline ‘only’ 22%, to a valuation of $31.2 trillion, to get to its ‘fair’ valuation with respect to the GDP.

How Useful is the Indicator for Investors

The last time when the indicator dipped below its moving average, was right after the 2008 financial crisis. In October 2008 Buffett wrote:

“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”

This was probably one of the best times to invest.

When it was below it throughout the 80s and one short dip in the early 90s were also good times to invest. On the other hand, throughout most of the 70s, the indicator was also below its average but stocks did perform poorly (although they did better than bonds in the inflationary environment. By far the best performing asset during that time was gold).

The problem of taking the average as an entering point, is that the indicator rarely dips below it. Hence, investors might forgo many good investment opportunities.

When we take the stock performance results based on the Historic Trend Line approach, we get a nice and regression trend line:

The y-axis shows the 5 year return and the x-axis shows the deviation from the mean trend line. The yellow line indicates where we are at the moment (+1 Std. deviation).

As expected, the trend line clearly suggests that the returns tend to be higher when the Buffet indicator is below the historic trend line. Based on the figure, we would expect a very slight, but still positive, return over the next 5 years.

Important to note is, that it is just a regression and the predictive value is small:

• If the stock market gets back up and makes new all-time highs and remains there for a while, this could quickly change the direction of the trend line.
• According to Currentmarketvaluation.com, the r-squared is low, meaning that the statistical significance of the predicting factors are low.
• It’s a time series, so autocorrelation might overstate the significance of the results: If one Month has a good return over 5 years, it is likely that the next month will show a similar result.

Conclusion

I think that artificial low interest rates have led to a flood of mountainous credit expansions and thereby totally obfuscated the price mechanism.

For this reason, I believe that a lot of the phenomena we see in the markets are symptoms of it.

One of these symptoms is an overblown stock market. 🎈

While I attribute some of the gains in the stock market, as compared to the underlying economy (measured by GDP), to the effects of globalization, I still think that the main culprit is the low interest rate.

Keeping this in mind, I think that the Buffett Indicator still offers a valuable tool for investors to assess the valuation of the broad stock market.