Today we are going to discuss the eighth of the nine market timing indicators we consider particularly useful for timing long-term market trends: the Buffett Model.
This is a valuation model (or indicator), measured as the percentage of total market cap relative to the Gross National Product (GNP), utilized by Warren Buffett (Trades, Portfolio) which, he has explained on many occasions, is "probably the best single measure of where valuations stand at any given moment."
Methodology
The basic postulate of the Buffett Market Timing Model is that, over the long run, stock market valuations will fluctuate between the historical mean value for the market cap to GNP series as well as some optimized upper bound representing k-standard deviations of the mean. A high current valuation that breaches the upper bound is likely to signal an overbought market and the expectation of lower future returns. On the other hand, a low current valuation closer toward the mean value, or below the mean value, of the series is likely to signal an oversold market and higher expected returns in the future.
The total market valuation is measured as the ratio of the total market cap to GNP. This ratio is similar to an economy's P/E ratio. How this ratio has trended since 1981 is shown in the chart below. We calculate and update this ratio with preliminary data quarterly. Finalized data comes directly from the World Bank.
To develop the indicator, we use data on Gross Domestic Product (GDP) rather than Gross National Product; the difference between the two is minimal. GDP is the total market value of final goods and services produced within a country's borders.
Market-cap figures include shares of listed domestic companies, shares of foreign companies that are exclusively listed on an exchange (i.e., the foreign company is not listed on any other exchange), common and preferred shares of domestic companies and shares without voting rights. Market capitalization figures exclude collective investment funds, rights, warrants, ETFs, convertible instruments, options, futures, foreign listed shares other than exclusively listed ones, companies whose only business goal is to hold shares of other listed companies, such as holding companies and investment companies, regardless of their legal status, and companies admitted to trading (i.e., companies whose shares are traded at the exchange but not listed at the exchange).
U.S. Standard & Poor's 500 findings
Based on the historical data, the market valuation lower bound is equal to the series mean (96%). The optimized market valuation upper bound is equal to the series mean plus one standard deviation (136%). Investors should expect higher (lower) long-term future returns when the market-cap/GDP ratio approaches the mean (upper bound).
Figure 1: S&P 500, Market Cap/GDP %, Upper and Lower Valuation Bands, 1981-2016
Interpretation
We can see that, during the past three decades, the market cap/GDP ratio has fluctuated widely. The lowest point was about 35% in the previous deep recession of 1982. The highest point was 174% during the tech bubble in 1999. The market went from extremely undervalued in the 1980s and early 1990s to extremely overvalued in the late 1990s and in 2000. Three years after the bursting of the tech bubble, when the S&P 500 was down 40%, long-term return prospects had improved as the market gap/GDP ratio approached the lower bound. Four years later the S&P 500 had climbed to new highs.
The upper bound was breached again in 2007, signaling lower expected future market returns. Investors reducing positions in equities would have been saved the painful market retreat of 2008. Higher expected long-term returns were signaled in 2008 and in 2009 following the market's collapse.
Today, the market cap/GDP ratio stands at 151%, 15% above the upper bound, implying an overbought market and lower expected returns.
Canada S&P/TSX findings
Based on the historical data, the market valuation lower bound is equal to the series mean (80%). The optimized market valuation upper bound is equal to the series mean plus one standard deviation (105%). Investors should expect higher (lower) long-term future returns when the market cap/GDP ratio approaches the mean (upper bound). That is, investors would be wise to increase their positions in equities when the market is oversold and decrease their positions when the market is overbought.
Figure 2: S&P/TSX, Market Cap/GDP %, Upper and Lower Valuation Bands, 1981-2016
Interpretation
The lowest point for the market cap/GDP ratio was about 33% in the previous deep recession of 1982. The highest point was 150% during the energy boom of 2007. The market went from extremely undervalued in the 1980s, 1990s and mid-2000s to significantly overvalued in 2006 and 2007. Two years after the collapse of the energy market and the great recession, when the S&P/TSX was down over 40%, long-term return prospects improved as the market cap/GDP ratio breached the lower bound signaling an oversold market. Seven years later the S&P/TSX had climbed to new highs.
The upper bound was breached in early 2010, signaling an overbought market and the expectation of lower future returns. Today, the market appears approximately fairly valued. The market cap/GDP ratio stands at 100%, 5% below the upper bound, implying a fairly valued market.
Stay tuned
Next week we will build on our discussion of market timing indicators by discussing the yield curve model.
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