Warren Buffett (Trades, Portfolio), the venerable boss of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) and undisputed master of value investing, needs no introduction in this forum; he is the ultimate value guru after all.
Yet, while followed closely as a stock picker, Buffett has also developed some thoughts on market timing. That’s “market timing” in the sense of identifying macroeconomic indicators that signal market trends, not timing in the sense understood by the traders amongst us.
The most famous of these indicators has been given the eponymous title of the "Buffett Indicator." The "Oracle of Omaha" has identified the indicator as a signal of overall value of stocks. And right now, the Buffett indicator is flashing red. Should investors be worried?
Introducing the Buffett indicator
The Buffett indicator is straightforward. It is simply the sum total of the market capitalization of all U.S. stocks relative to gross domestic product. According to Buffett, "It is probably the best single measure of where valuations stand at any given moment.”
When stocks overall are trading well below GDP, then that is a generalized "buy" signal. Meanwhile, if stocks are valued significantly higher than GDP, then stocks have been bid up beyond reasonable value. Of course, there are opportunities in either set of circumstances to find value in individual securities (even in this long bull run where everything has started to look expensive).
Qhen the aggregate U.S. market cap growth outstrips GDP growth for a lengthy period, however, it is a clear signal that market confidence is out of step with the broader economy. Yes, much economic interaction is conducted in the private sphere and there are innumerable businesses that do not trade on the stock market. But, as Buffett would no doubt point out, America’s public companies are by far the largest economic players in the country and their fortunes are, of necessity, tied to those of the broader economy to a large degree.
Signaling highs and lows
The aggregate stock market cap rushing onward faster than GDP for multiple years is liable to signal a mismatch between market sentiment and what is really happening. Ultimately, everything comes down to fundamentals. Thus, if the market has rushed ahead of the economy, a correction is ultimately inevitable. This appears to have played out according to Buffett’s theory over the past couple cycles.
At the height of the dot-com bubble, the aggregate U.S. market cap stood at 136.9% of GDP. When it burst, the ratio tipped below 100% for several years. The next time it rose above 100%, it was only for a short span, topping out at about 105% in 2008. That was just before the financial crisis sent the stock market into a tailspin, with the ratio hitting a low of 56.8% in the teeth of the Great Recession.
Indicator flashing red
As the recession dissipated, the economy began its slow recovery and market nerves settled. The economic expansion and market bull run that followed the end of the recession has been one of the longest in history. Market confidence has led to enthusiastic valuation multiples across U.S. stocks. The result has been a Buffett indicator above 100% for years, with the ratio continuing to climb with only temporary reversals.
Currently, the Buffett indicator shows the stock market to be valued at about 140% of GDP. That is the highest it has ever been, beating out the peak of the dot-com bubble by a few percentage points. If past events are predictive of the future, then this is a danger signal.
In essence, stocks across the board are valued very highly. Expansionary fiscal and monetary policy under the Obama and Trump administrations have helped to juice the bull run. As memories of the financial crisis fade, it is easy to see market participants starting to believe the age-old maxim: “It’s different this time.” But it never is.
If the Buffett indicator is to be believed, the market is in a dangerous position. The ratio has, so far, continued to expand, but as full employment looms and trade conflicts bite, it is hard to imagine that the current bull market can soldier on at this pace for good.
Are we on the immediate cusp of a big correction or economic downturn? Probably not. But the danger signals are increasing and the higher the disconnect between market sentiment and economic reality becomes, the worse the correction is likely to be.
Problems with the indicator
As with any simple indicator or signal, the Buffett indicator lacks nuance and makes assumptions that may not necessarily hold up.
One problematic assumption, for example, is that tax rates remain constant. Yet this is frequently not the case. There are also structural issues, such as the fact that the indicator does not account for dual listings. While these may distort the indicator, they are comparatively minor.
There is also the issue of private business and other assets. We addressed some of this earlier, and it still stands that the stock market as a whole can be called a proxy for the big engines of the economy to a degree. However, it does not properly account for other major economic assets, such as real estate. Yes, there are real estate investment trusts. And we know that REITs have been crowding into major market indexes of late. But the vast majority of real property is still not accounted for in a stock market context.
Perhaps the most distortive issue is a function of global commerce. We mentioned earlier in this section the fact that dual listings might present issues. More importantly, publicly traded U.S. companies are frequently global businesses that seek out new markets to exploit around the world. Because of this, the growth of companies’ profits (and thus their valuations) may not move in lockstep with the economic output of the country in which they are listed. Indeed, the United States has a mature economy with relatively low economic growth compared to parts of the developing world. With publicly traded American businesses raking in profits from these growing sections of the world economy, it should be unsurprising that stocks accelerate at a faster pace than the U.S. GDP.
A final consideration worthy of mention is the lack of adequate historical data points. Looking back 50 years, there have been only three periods (including the present one) in which the indicator was above 100%. That means that, during a number of market cycles, the Buffett indicator failed to flash a significant danger signal. There were peaks and troughs that correlate fairly accurately with the concept of the indicator. For instance, a peak in the indicator was followed by a drop and vice versa. But without an anchoring point, there was no meaningful signal to respond to. That is a bad sign for any market indicator’s predictive and strategic value.
Our take
Ultimately, every market indicator, signal or ratio is flawed. It is critical to aggregate signals and use them to build a picture that mirrors reality as closely as possible. The Buffett indicator is worth keeping an eye on, especially in these heady times in which stocks are rushing ahead of economic growth at a rate that is intuitively unsustainable.
The Buffett indicator seems to work best as a check against those intuitions. As in the current market, we can see eye-watering valuations seemingly across the board. Looking at the Buffett indicator helps substantiate and instantiate those intuitions and observations, without necessarily offering much in the way of prescriptive aid.
Stocks may reflect a more global outlook and be driven by more than the economy. But ultimately, the fortunes of an economy and those of the businesses that operate within them are tightly linked. That means the Buffett indicator is worth keeping track of on an ongoing basis. But don’t base your investing strategy on it!
Disclosure: I/We own no stocks discussed in this article.
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