Buffett’s Flashing Red Stock Market Indicator That You Need To Be Aware Of

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Firstly, there are several indicators employed to gauge stock market valuations. The market price to earnings ratio (P/E) is among the most common. Legendary investor, Warren Buffett analyses another indicator, which has famously become synonymous with his name. It compares the total market capitalisation of the entire U.S. Stock Market against the total GDP (gross domestic product) of the U.S. And guess what? It’s flashing bright red. Here’s what you need to know.

What Does The Buffett Indicator Do?

The total stock market capitalization to GDP indicator is measuring whether the overall market is overvalued or undervalued. Historically, GDP and stocks have always risen over time. The relationship between GDP and equity prices should be somewhat synchronized, but markets aren’t always logical. In times of fear and uncertainty, stocks can get undervalued. At other times of greed, stocks can become insanely overvalued. As a result, the market capitalisation to GDP ratio attempts to assess if stocks are pricey or on sale. 

How is the Buffett Indicator Measured?

The Buffett indicator is measured simply by comparing the total market capitalisation of the entire U.S. Stock Market against the total GDP of the United States. The Wilshere 5000 Total Market Index is typically used to calculate the market capitalisation of all publically traded stocks in the U.S. The Wilshere 5000 is a market cap weighted index comprising of over 6,700 publically listed U.S companies. Quarterly GDP figures are used as the denominator in this equation. Should you rather see things visually, the equation is illustrated below.

Source: Investopedia

Where is it now?

At the time of writing (February 2020), the Buffett Indicator was sitting at a record high level of around 150% following a steady climb from its low during GFC in 2009. For context, just prior to the dotcom bubble bursting in March 2000, the Buffett indicator was recorded at 148%. It quickly bottomed out at 74% in September 2002 following the dot-com crash. Furthermore, this chart by GuruFocus sums up the history of the indicator quite nicely.

Source: GuruFocus

According to GuruFocus and based on historical valuations, the Buffett indicator can be divided into the following 5 zones based upon varying percentage bracket levels. 

Ratio (Total Market Cap/GDP X 100)Valuation
0% – 50%Significantly Undervalued 
50%-75%Modestly Undervalued
75%-90%Fair Value
90%-115%Modestly Overvalued
> 115% Significantly Overvalued
Q1 2020? (02/02/2020)150% (Significantly Overvalued)

So what does a significantly overvalued categorization mean? Historically, higher valuations in the stock market today have generally corresponded with lower future returns over the long term. In contrast, lower valuations levels coincide with higher long-term returns.

Investing at a reasonable price is key to a successful investment. But, some might argue that time in the market is better than timing the market because of the stock markets’ cyclical nature. Because markets are cyclical, valuations eventually correct back to their average. But eventually, we’re all dead anyway, so it’s important to invest at the right price to ensure you’re not waiting a lifetime to get your money back.

What does it mean for you and me?

Firstly, let me remind you that no one can time the market perfectly, or at least that no one that I’ve heard of. Because we can’t time the market perfectly, It would be foolish to adjust asset allocations by forecasting market peaks and bottoms. Rather than attempting to time the market, we can employ indicators like the Buffett Indicator to determine the risk factors associated with certain asset classes in comparison to others.

Above all, It’s important to note that The Buffett Indicator should not be used as in isolation when determining which asset classes will perform better than others. Investment horizon, diversification, risk tolerance among other factors should always be considered along with market valuation indicators.

That being said, the Buffett Indicator does provide us with great insight into the market’s historical reactions to higher or lower valuations.

Summary

In summary, it’s clear that Buffett’s sentiment is running in parallel with the indicator aligned with his name. Buffett told shareholders in his 2018 letter that “In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.” You can see the entire letter here. 

Berkshire Hathaway, Buffett’s holding company has also amassed its largest cash pile in the companies history. It currently sits somewhere in the realm of 128 Billion USD. Berkshire’s gargantuan cash pile suggests they’re struggling to find any value in the stock market at current levels.  

The US Stock Market is priced higher than it’s ever been in relation to GDP and the world’s greatest investor is clearly struggling to find value in this market. If there’s one thing I’ve learned about the investing world, it’s when Buffett acts you stop whatever you’re doing and take note. I know I am. 

P.S. I’d love to meet you on Twitter: here.

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Disclaimer: This website (The Money Pal”) is published and provided for informational and entertainment purposes only.  The information in the Blog constitutes the Content Creator’s own opinions. The information should not be regarded as financial advice.

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