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Buffett Indicator: Global Stock Market Valuations and Expected Future Returns

Updated at Tue, 19 Jan 2021 20:30:05 -0600

Where Are We with Global Market Valuations?

Before we start, we would like to point out that at the left sidebar of this page you can find the implied future returns of the world’s 18 largest stock markets, sorted from the highest return to the lowest for developed markets and emerging markets.

Since we published the market valuation and implied future return based on the percentage of total market cap (TMC) relative to the U.S. GNP, it has served as a good indicator for the overall market valuation of the U.S. stock market. We have also added the Shiller P/E page, which looks at the market valuation from a normalized earnings perspective, and gives similar conclusions on overall market valuations and future market returns.

Those two pages have served the U.S. market very well. However, a lot of users asked us about the international market. Indeed, sometimes investors are better served to invest internationally. The purpose of this page is to provide an overview of the stock market valuations of the 18 largest economies in the world. The indicator we use is still the percentages of the total market caps of these countries over their own GDPs.

As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.” Unlike the U.S. market, the histories of the data for other countries are not long enough to provide a more accurate projection of future returns. But still we believe that this page can give a good idea on where the market stands currently with overall valuations.

Before we get into the details of how we arrived at our results, these are the implied returns of the stock market worldwide, including both developed markets and emerging markets, as displayed in the left sidebar. This page is updated daily.

Assumptions about Finding out the Implied Future Returns of the Stock Market

We have discussed in great detail how to calculate the future returns of the market for the U.S. market. The principle is the same for the stock market. Three factors contribute to future market returns. These three factors are:

  1. Future business growth: We assume that average future growth will be the same as past growth. This may overestimate growth for fast-growing economies.
  2. Dividends: The average future dividends per year in the next five years will be equal to the average of the last five years. This may underestimate dividend yield as in general, dividends will grow as economies grow.
  3. Change in market valuation: A big assumption here in the market valuation is that the ratio of market cap to GDP will revert to its previous mean during a full market cycle, which will last 7-8 years.

Total investment return is given by:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

Data Sources:

  1. Future business growth: Similar to what we did for the U.S. market, we estimate the future business growth using the past GDP growth of these countries. The GDP data we use is either from the reported data of the statistics departments of these countries or data published by the World Bank. For some of these countries, only annual data is available.
  2. Dividends: We use the dividends of the corresponding iShares country ETF to estimate the current dividend yield of the country’s stock market. While the dividends of these ETFs were never consistent, we use the average of the dividends of the ETFs over the last five years to estimate future dividends.
  3. Change in market valuation: As detailed in the U.S. market valuation, we use the Wilshire Total Market index to estimate the total market cap of the U.S. market. However, no similar indexes exist for other countries. Instead we use the most dominant market indexes in those countries as proxies of the total market indexes. We assume that these indices change proportionally with the total market. These indexes are then converted to the total market cap based on the ratios of total market cap over GDP data published by the World Bank.

The details of the indexes we used for different countries are in the page for each country. Click on the country’s name on the left sidebar to check out.

Error Sources:

The sources of errors are from the assumptions:

  1. Future average GDP growth might be different from past growth. This can be especially true for countries of emerging markets that have high growth rates. The slowdown can affect the results dramatically.
  2. We are using GDP data instead of GNP data for the calculations.
  3. In most cases the index we use covers at least 70% of the total market in the country. But the total market may deviate slightly from the index.
  4. The mean of the historical valuation may not be the mean for the future, especially when we do not have enough historical data.

How to interpret the data:

If we have less than 20 years of data, the history of the data is certainly too short for an accurate prediction of future returns. The current ratio of market cap over GDP in this page gives you an idea on where the market stands from historical perspective.

We may not come to an accurate projection for future returns, especially for emerging markets. But we believe that this page can give us a good idea on where we stand for different countries in terms of historical market valuations.

Detailed Data and Discussions:

This page presents the market valuation of the 18 largest economies in the world. The market valuation is measured by the ratio of total market cap to GDP. These are the GDPs in U.S. dollars for these countries. Original GDP data was in each country’s national currency. They are converted into the U.S. dollar using the latest exchange rate.

As listed, the U.S. has the largest economy, followed by China, Japan, Germany, etc. The market cap of the U.S. is also the largest. However, the market caps of other countries do not display as monotone a decline as the GDP, as shown in the chart below:

As the results, the ratio of the total market cap over GDP for the countries from the largest economy to the smallest is shown below:

Putting your mouse over the columns of the chart you will find the exact current total market cap over GDP ratios for each country. We can see that the ratio varies dramatically across different countries. Historically these ratios swing wildly. For instance, the ratio of total market cap over GDP climbed to 355% in 1989, when Japan’s economy was booming and nothing could stop the country of the rising sun. But the ratio sank to as low as 60% in 2003 and 2009, when the country of the rising sun seemed to have plunged into permanent darkness. The chart below is the current ratio of total market cap over GDP and its historical range. It is also listed in the table at the left side of the chart. The data is updated daily.

CountryGDP ($Trillion)Total Market/GDP Ratio (%) Historical Min. (%)Historical Max. (%) Years of DataCountry ETF
Hong Kong0.391113.21571.842363.3131EWH

Historical minimum and maximum,  and current ratio of total market cap over GDP

As we discussed above, the total returns of the future market come from three factors: GDP growth, dividend yield and change of overall market valuation. Assuming the market valuation will revert to the historical mean, the contributions from each component are listed in the table. The countries are separated into developed market and emerging market. Only the countries that have at least 10 years of data are displayed.

Contributions from GDP Growth

These are the past GDP growth rate of these countries. Apparently developing countries had much faster growth than developed countries. This may over-estimate the future returns of the emerging market.

Contributions from Dividend Yield

The average of the dividend payment of the country ETFs over the last five years was used to estimate the dividend yield. Yield is calculated by dividing the dividend by the current prices of the corresponding ETFs.

Contributions from Valuation Reverse to the Mean

Assuming the market valuation will reverse to the mean over the next 8 years, these are the contribution from mean reversion of the market valuation.

Again, these are the total returns from all the three components for these countries:

We can clearly see that for the emerging market, the contribution from economic growth is much higher than in the developed market. For instance, the average growth for China’s economy is more than 16% a year for the eight-year period before 2012; India’s economy averaged about 15% of growth a year. These high growth rates contributed to the future returns substantially.

But on the other hand, the economic growth of these countries cannot continue at these rates forever. They may slow down drastically in the future. Considering these factors and the shorter history of data, we believe that the implied returns for the emerging market carry much higher uncertainty.

On the other hand, the projection for developed countries should be much more reliable, especially when we have a longer history of data available. The U.S. market valuation page has done a decent job in predicting the future returns of the U.S. market.

Click on the country on the left sidebar to check out the details for each country.


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