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James Li
James Li
Articles (328)  | Author's Website |

US Market ‘Spookily Overvalued’ on Halloween

Buffett indicator still near record highs

October 31, 2017 | About:

Warren Buffett (Trades, Portfolio)’s market indicator reached 137.2% Oct. 31, the day Americans celebrate Halloween. The ratio of the Wilshire 5000 to the U.S. gross domestic product has remained significantly overvalued, as discussed in a previous article. Based on this valuation, the U.S. stock market is expected to return -1.5% per year over the next eight years.

Buffett indicator stays overvalued

The Wilshire 5000 index stands at $26.783 trillion, approximately 1.372 times greater than the last-reported gross domestic product of $19.5 trillion. Including a dividend yield of 1.86% and a GDP growth rate around 3.15%, the expected return of the U.S. stock market in the next eight years is -1.5%.

1509485767904.png

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A reminder of how we compute predicted and actual returns

The Berkshire Hathaway Inc. (NYSE:BRK.A)(NYSE:BRK.B) CEO mentioned the ratio of the total market cap to the gross domestic product is “probably the best single measure of where stock market valuations stand at any given moment.” We can compute the expected market return as the sum of three parts: the dividend yield, the GDP growth rate and the “valuation reversion to the mean” return.

The GDP growth rate is an eight-year growth rate, i.e., we take the ratio of the current GDP over the GDP eight years ago, raise it to the one-eighth power and subtract one. For the “valuation reversion to the mean” calculation, we consider three cases:

  • The “optimistic case,” where the Buffett indicator averages 120% over the next eight years.
  • The “expected case,” where the Buffett indicator averages 80% over the next eight years.
  • The “pessimistic case,” where the Buffett indicator averages 40% over the next eight years.

For each case, we compute the predicted return based on the following formula:

Investment return = yield + growth rate + (ending ratio / current ratio) ^ (1/8) -1

As of Oct. 31, the predicted returns are shown in the chart below. The red, blue and green lines show the predicted returns for the optimistic case, the expected case and the pessimistic case respectively. The yellow line reports the actual returns: for each quarter, we first compute the ratio of the Wilshire 5000 index price 32 quarters later to the Wilshire 5000 index price for that quarter. We then raise this to the one-eighth power and subtract one to get the actual return.

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See also

We can expand this “Buffett indicator” principle to global markets. GuruFocus currently provides stock market valuation data for 21 of the largest stock markets around the world. The first chart illustrates the ratio of total market index to the GDP, while the second chart illustrates the implied market returns for the global markets.

If we can compute the predicted and actual returns for the U.S. market, we should be able to extend this to the global markets as well. One of our upcoming GuruFocus features will discuss the predicted and actual returns for the global markets.

Disclosure: The author has no positions in the stocks mentioned.

About the author:

James Li
I am an editorial assistant and researcher at GuruFocus. I have a Master's in Finance from SMU, and I enjoy writing reports on financial trends and investor portfolios. Follow me on Twitter at @JamesLiGuru!

Visit James Li's Website


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TodWong
TodWong - 2 weeks ago    Report SPAM

When is the time to return normal?

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