Buffett indicator

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The Buffett indicator (or the Buffett metric, or the Market capitalization-to-GDP ratio) is a valuation multiple used to assess how expensive or cheap the aggregate stock market is at a given point in time. It was proposed as a metric by investor Warren Buffett in 2001, who called it "probably the best single measure of where valuations stand at any given moment", and its modern form compares the capitalization of the US Wilshire 5000 index to US GDP.{{efn|Note that slightly different Buffett indicators can be calculated when using the S&P 500 index, or using different definitions of GDP, and even using GNP (Buffett's original divisor).}} It is widely followed by the financial media as a valuation measure for the US market in both its absolute,{{cite web | website=VisualCapitalist | url=https://www.visualcapitalist.com/the-buffett-indicator-at-all-time-highs-is-this-cause-for-concern/ | title=The Buffett Indicator at All-Time Highs: Is This Cause for Concern? | first=Carmen | last=Ang | date=17 February 2021 | access-date=18 February 2021}} and de-trended forms.

The indicator set an all-time high during the so-called "everything bubble", crossing the 200% level in February 2021; a level that Buffett warned if crossed, was "playing with fire".

History

On 10 December 2001, Buffett proposed the metric in a Fortune essay co-authored with journalist Carol Loomis. In the essay, Buffett presented a chart going back 80 years that showed the value of all "publicly traded securities" in the US as a percentage of "US GNP". Buffett said of the metric: "Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal".

Buffett explained that for the annual return of US securities to materially exceed the annual growth of US GNP for a protracted period of time: "you need to have the line go straight off the top of the chart. That won't happen". Buffett finished the essay by outlining the levels he believed the metric showed favorable or poor times to invest: "For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire".{{cite magazine | magazine=Fortune | url=https://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/index.htm | title=Warren Buffett On The Stock Market | first1=Warren | last1=Buffett | first2=Carol | last2=Loomis | author1-link=Warren Buffett | author2-link=Carol Loomis | date=10 December 2001 | access-date=18 February 2021 | quote=What's in the future for investors--another roaring bull market or more upset stomach? Amazingly, the answer may come down to three simple factors. Here, the world's most celebrated investor talks about what really makes the market tick--and whether that ticking should make you nervous.}}{{cite magazine | magazine=Forbes | url=https://www.forbes.com/sites/jonathanponciano/2021/02/12/is-the-stock-market-about-to-crash/?sh=3cd9296c71de | title=Is The Stock Market About To Crash? | first=Jonathan | last=Ponciano | date=12 February 2021 | access-date=14 February 2021}}

Buffett's metric became known as the "Buffett Indicator", and has continued to receive widespread attention in the financial media,{{cite web | website=Bloomberg | url=https://www.bloomberg.com/news/articles/2021-02-12/warren-buffett-s-favorite-valuation-metric-is-ringing-an-alarm | title=Warren Buffett's Favorite Valuation Metric Is Ringing an Alarm | first1=Michael P.| last1=Regan | first2=Vildana | last2=Hajric | first3=Claire |last3=Ballentine | date=12 February 2021 | access-date=13 February 2021}}{{cite web | website=Business Insider | url=https://markets.businessinsider.com/news/stocks/warren-buffett-indicator-record-high-overvalued-stock-market-crash-2021-2-1030067388 | title=Warren Buffett's favorite market indicator soars to record high, signaling stocks are overvalued and a crash may be coming | first=Theron | last=Mohamed | date=10 February 2021 | access-date=18 February 2021}}{{cite news | newspaper=Wall Street Journal | url=https://www.wsj.com/articles/moneybeat-buffett-indicator-flares-1434330072 | title=MoneyBeat: Buffett Indicator Flares | first=Kristen | last=Scholer | date=14 June 2015 | access-date=18 February 2021}}{{cite magazine | magazine=Barron's | url=https://www.barrons.com/articles/future-returns-the-value-gap-is-too-big-to-ignore-01612279142 | title=Future Returns: The Value Gap Is Too Big to Ignore | first=Sarah | last=Max | date=2 February 2021 | access-date=18 February 2021}} and in modern finance textbooks.{{cite book | title= The Conceptual Foundations of Investing: A Short Book of Need–to–Know Essentials | first1= Shaun | last1=Cornell | first2=Bradford | last2=Cornell | first3=Andrew | last3=Cornell | isbn=978-1119516293 | publisher=Wiley | edition=1st | date=December 2018}}{{cite book | title=Japanese Equities: A Practical Guide to Investing in the Nikkei | first=Michiro | last=Naito | isbn=978-1119603665 | publisher=Wiley | edition=1st | date=October 2019}}

In 2018, finance author Mark Hulbert writing in the Wall Street Journal, listed the Buffett indicator as one of his "Eight Best Predictors of the Long-Term Market".{{cite news | newspaper=Wall Street Journal | url=https://www.wsj.com/articles/the-8-best-predictors-of-the-long-term-market-1533521521?source=content_type%3Areact%7Cfirst_level_url%3Aarticle%7Csection%3Amain_content%7Cbutton%3Abody_link | title=The Eight Best Predictors of the Long-Term Market | first=Mark | last=Hulbert | author-link=Mark Hulbert | date=5 August 2018 | access-date=21 February 2021}}

A study by two European academics published in May, 2022 found the Buffett Indicator "explains a large fraction of ten-year return variation for the majority of countries outside the United States".Swinkels, Laurens and Umlauft, Thomas S., The Buffett Indicator: International Evidence (March 30, 2022). Available at SSRN: https://ssrn.com/abstract=4071039 or http://dx.doi.org/10.2139/ssrn.4071039 The study examined 10-year periods in fourteen developed markets, in most cases with data starting in 1973. The Buffett Indicator forecasted an average of 83% of returns across all nations and periods, though the predictive value ranged from a low of 42% to as high as 93% depending on the specific nation. Accuracy was lower in nations with smaller stock markets.

Theory

Buffett acknowledged that his metric was a simple one and thus had "limitations", however the underlying theoretical basis for the indicator, particularly in the US, is considered reasonable.

For example, studies have shown a consistent and strong annual correlation between US GDP growth, and US corporate profit growth, and which has increased materially since the Great Recession of 2007–2009.{{cite web | website=NASDAQ | url=https://www.nasdaq.com/articles/what-relationship-between-corporate-profits-and-gdp-2015-10-30 | title=What Is the Relationship Between Corporate Profits and GDP? | first=Steven | last=Hansen | date=15 October 2015 | access-date=19 February 2021}} GDP captures effects where a given industry's margins increase materially for a period, but the effect of reduced wages and costs, dampening margins in other industries.

The same studies show a poor annual correlation between US GDP growth and US equity returns, underlining Buffett's belief that when equity prices get ahead of corporate profits (via the GNP/GDP proxy), poor returns will follow.{{cite web | website=MSCI | url=https://www.msci.com/documents/10199/a134c5d5-dca0-420d-875d-06adb948f578 | title=Is There a Link Between GDP Growth and Equity Returns? | date=May 2010 | access-date=19 February 2021}} The indicator has also been advocated for its ability to reduce the effects of "aggressive accounting" or "adjusted profits", that distort the value of corporate profits in the price–earnings ratio or EV/EBITDA ratio metrics; and that it is not affected by share buybacks (which don't affect aggregate corporate profits).

The Buffett indicator has been calculated for most international stock markets, however, caveats apply as other markets can have less stable compositions of listed corporations (e.g. the Saudi Arabia metric was materially impacted by the 2018 listing of Aramco), or a significantly higher/lower composition of private vs public firms (e.g. Germany vs. Switzerland), and therefore comparisons across international markets using the indicator as a comparative measure of valuation are not appropriate.{{cite web | website=CFA Institute | url=https://blogs.cfainstitute.org/investor/2021/01/29/the-buffett-indicator-revisited-market-cap-to-gdp-and-valuations/ | first= Navin | last=Vohra | date=29 January 2021 | access-date=18 February 2021 | title=The Buffett Indicator Revisited: Market Cap-to-GDP and Valuations }}

The Buffett indicator has also been calculated for industries (but also noting that it is not relevant for cross industry valuation comparison).{{cite book | url=https://www.worldscientific.com/doi/abs/10.1142/9789813149311_0026 | chapter=Chapter 26: Understanding Buffett Indicators in Different Industries | title=Business Analytics | pages=685–710 | doi=10.1142/9789813149311_0026 | first=Jorge L.C | last=Sanz | date=2016 | isbn=978-9813149304 | access-date=19 February 2021}}

=Trending=

There is evidence that the Buffett indicator has trended upwards over time, particularly post 1995, and the lows registered in 2009 would have registered as average readings from the 1950–1995 era. Reasons proposed include that GDP might not capture all the overseas profits of US multinationals (e.g. use of tax havens or tax structures by large US technology and life sciences multinationals), or that the profitability of US companies has structurally increased (e.g. due to increased concentration of technology companies), thus justifying a higher ratio; although that may also revert over time. Other commentators have highlighted that the omission by metric of corporate debt, could also be having an effect.

Formula

Buffett's original chart used US GNP as the divisor, which captures the domestic and international activity of all US resident entities even if based abroad, however, many modern Buffett metrics use US GDP as the metric.{{cite magazine | magazine=Fortune | title=One of Warren Buffett's Favorite Metrics Is Flashing Red—a Sign That Corporate Profits Are Due for a Hit | first=Shawn | last=Tully | date=19 June 2019 | access-date=18 February 2021 | url=https://fortune.com/2019/07/17/warren-buffett-cap-ratio-tmc-gdp/ }} US GDP has historically been within 1 percent of US GNP, and is more readily available (other international markets have greater variation between GNP and GDP).{{cite web | website=St. Louis Federal Reserve | url= https://fred.stlouisfed.org/graph/fredgraph.png?g=gR4 | title=US GDP vs. US GNP | access-date=18 February 2021}}

Buffett's original chart used the Federal Reserve Economic Data (FRED) database from the Federal Reserve Bank of St. Louis for "corporate equities",{{efn|Or more technically, item NCBEILQ027S, from Line 62 in the F.103 balance sheet of Table S.5.q of the "Integrated Macroeconomic Accounts for the United States" (Market Value of Equities Outstanding) file.{{cite web | website=AdvisorPerspectives | date=4 February 2021 | first=Jill | last=Minski | url=https://www.advisorperspectives.com/dshort/updates/2021/02/04/market-cap-to-gdp-an-updated-look-at-the-buffett-valuation-indicator | title=Market Cap to GDP: An Updated Look at the Buffett Valuation Indicator | access-date=18 February 2021}}}} as it went back for over 80 years; however, many modern Buffett metrics simply use the main S&P 500 index, or the broader Wilshire 5000 index instead.{{cite web | website=Corporate Finance Institute | url=https://corporatefinanceinstitute.com/resources/knowledge/valuation/market-cap-to-gdp-buffett-indicator/ | title=Market Cap to GDP Ratio (the Buffett Indicator) | date=2021 | access-date=18 February 2021}}

A common modern formula for the US market, which is expressed as a percentage, is:{{cite web | website=CurrentMarketValuation | url=http://www.currentmarketvaluation.com/models/buffett-indicator.php | title=The Buffett Indicator | date=11 February 2021 | access-date=18 February 2021}}

: $\operatorname{Buffett\ indicator} = \frac{\operatorname{Wilshire\ 5000\ capitalization}}{\operatorname{US\ GDP}}\times 100$

(E.g. if US GDP is USD 20 trillion and the market capitalization of the Wilshire 5000 is USD 40 trillion, then the Buffett indicator for the US is 200%; i.e. US public companies are twice as big as annual US economic output.)

The choice of how GDP is calculated (e.g. deflator), can materially affect the absolute value of the ratio; for example, the Buffett indicator calculated by the Federal Reserve Bank of St. Louis peaks at 118% in Q1 2000,{{cite web | website= Federal Reserve Bank of St. Louis | title=Wilshire 5000 Total Market Full Cap Index/Gross Domestic Product (GDP at 2007 prices) | access-date=19 February 2021 | url=https://fred.stlouisfed.org/graph/?g=qLC}} while the version calculated by Wilshire Associates peaks at 137% in Q1 2000,{{cite web | website=Statista | url=https://www.statista.com/chart/21972/market-capitalization-to-gdp-ratio/ | date=9 February 2021 | access-date=19 February 2021 | first=Felix | last=Richer | title=Are We in a Stock Market Bubble?}} while the versions following Buffett's original technique, peak at very close to 160% in Q1 2000.

Records

Using Buffett's original calculation basis in his 2001 article, but with GDP, the metric has had the following lows and highs from 1950 to February 2021:

A low of 33.0% in 1953, a low of 32.2% in 1982, and a low of c. 79% in 2002, and a low of 66.7% in 2009
A high of 87.1% in 1968, a high of 159.2% in 2000, a high of c. 118% in 2007, and a high of 189.6% in (Feb) 2021.

Using the more common modern Buffett indicator with the Wilshire 5000 and US GDP, the metric has had the following lows and highs from 1970 to February 2021:

A low of 34.6% in 1982, a low of 72.9% in 2002, and a low of 56.8% in 2009
A high of 81.1% in 1972, a high of 136.9% in 2000, a high of 105.2% in 2007, and a high of 172.1% in (Feb) 2021.

De-trended data of Buffett's original calculation basis (see above) has had the following lows and highs from 1950 to February 2021 (expressed a % deviation from mean):

A low of -28% in 1953, a low of -51% in 1982, and a low of -5% in 2002, and a low of -27% in 2009
A high of +58% in 1968, a high of +96% in 2000, a high of c. +30% in 2007, and a high of +80% in (Feb) 2021.

Notes

References

External links

[https://www.investopedia.com/terms/m/marketcapgdp.asp Stock Market Capitalization-to-GDP Ratio] (Investopedia, January 2021)
[https://corporatefinanceinstitute.com/resources/knowledge/valuation/market-cap-to-gdp-buffett-indicator/ Market Cap to GDP Ratio (the Buffett Indicator)] (Corporate Finance Institute, 2021)
[https://buffettindicator.net Buffett Indicator] (BuffettIndicator.net, 2024)
[https://www.gurufocus.com/stock-market-valuations.php Buffett Indicator: Where Are We with Market Valuations?] (GuruFocus, 2021)
[https://www.longtermtrends.net/market-cap-to-gdp-the-buffett-indicator/ Market Cap to GDP: The Buffett Indicator] (LongTermTrends, 2021)

Category:Financial ratios

Category:Valuation (finance)

Category:2000 neologisms

Category:2000s in economic history

Category:Economic indicators

Category:Economics neologisms