The Buffet Market Indicator

By April 15, 2019 Blog

Warren Buffett has commented on several occasions that one market indicator he tracks is the ratio of the aggregate value of the stock market to GDP.  Data from the Center for Research in Securities Prices (CRSP) makes this ratio easy to track because CRSP directly reports the total market value of all listed stocks.  So, let’s get right to it and see what the Buffett indicator can tell us.

The basic Buffett indicator, the ratio of stock market value to GDP, is the blue line in the exhibit below.  The graph effectively shows that the indicator is at an all time high. (To be clear, the data in the graph only run through the end of 2018 and the market drop in December 2018 is clearly visible.  However, the market has now more than fully recovered from the drop so the indicator is at an all time high.) There is a problem, however, drawing the conclusion that the raw Buffett indicator implies record overvaluation because there is clearly an upward trend in the data.  The trend is confirmed by fitting a simple straight line to the data. That line is shown in orange is visibly upward sloping.

When a series is a trend comparing raw numbers will be misleading because more current observation will tend to be higher than earlier ones.  The standard way to solve this problem is to look at deviations from the trend rather than raw numbers. The deviations from the linear trend are plotted in red on the exhibit.  Based on the deviations, the current market level is still extraordinarily high, approximately equal to its level at the end of 1928. The only time when the deviation exceeds its current level is at the height of the tech stock boom in 2000.

Before going further, a word about trends.  The trend in the value of the market to GDP looks much like the trend in price-earnings ratios – both have risen since 1926.  That should not be interpreted to mean that the trend will continue. In fact, it cannot. There must be a limit on how high stock prices can rise relatively to GDP and earnings because ultimately it is economic activity and corporate earnings that produce cash flows for equity holders.  It may be hard to predict when the trend will stop, but it is clear that it must, and that fact should be taken into account when evaluating measures like the Buffett indicator.

The foregoing caveats aside, the Buffett measure is another reason why we believe that current stock market is richly valued.  In our view, as we have said before, current conditions warrant caution and reduced exposure to market risk.

Leave a Reply