What is the Buffet Indicator?
Buffett Indicator Overview
The Buffett Indicator (aka, Buffett Index, or Buffett Ratio) is the ratio of the total United States stock market to GDP. The Buffett indicator 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. It is widely followed by the financial media as a valuation measure for the US market.
“The Buffett Indicator expresses the value of the US stock market in terms of the size of the US economy. If the stock market value is growing much faster than the actual economy, then it may be in a bubble.”
This ratio fluctuates over time since the value of the stock market can be very volatile, but GDP tends to grow much more predictably. The current ratio of 199% is approximately 62.13% (or about 2.0 standard deviations) above the historical trend line, suggesting that the stock market is Strongly Overvalued relative to GDP.
Buffett Indicator Theory
The Buffett Indicator is the ratio of total US stock market value divided by GDP. To calculate the ratio, we need to get data for both metrics: Total Market Value and GDP.
Total Market Value
The most common measurement of the aggregate value of the US stock market is the Wilshire 5000. This is available directly from Wilshire, with monthly data starting in 1971, and daily measures beginning in 1980. The Wilshire index was created such that a 1-point increase in the index corresponds to a $1 billion increase in US market cap. Per Wilshire, that 1:1 ratio has slightly drifted, and as of 2020 a 1-point increase in the index corresponded to a $1.05 billion dollar increase.
GDP
GDP (Gross Domestic Product) represents the total annual production of the US economy. It is measured quarterly by the US Government's Bureau of Economic Analysis. GDP is a static measurement of prior economic activity. It does not forecast the future or include any expectation or valuation of future economic activity or economic growth.
GDP is calculated and published quarterly, several months in arrears, such that by the time the data is published it is for a quarter that ended several months ago. The Federal Reserve Bank of Atlanta publishes GDPNow, an estimate of the current quarter's GDP growth rate, which can be used to calculate an estimate for the current month's (annualized) GDP value of $28.06 trillion dollars.
Criticisms of the Buffett Indicator
No single metric is illustrative of the health or relative valuation entire market. Common criticisms of the Buffett Indicator are:
Interest Rates
The Buffett Indicator only considers the value of the stock market, but does not consider how stocks are valued relative to alternative investments, such as bonds.
When interest rates are high, bonds pay a high return to investors, which lowers demand (and prices) of stocks. Additionally, higher interest rates means it's more expensive for businesses to borrow money, making it harder to borrow cash as a way to finance growth. Any business that takes on debt will face relatively higher interest payments, and therefore fewer profits. Less corporate profits means lower corporate stock values. The corollary to this is also true. Low interest rates means bonds pay less to investors, which lowers demand for them, which raises stock prices in relation to bonds. Low interest rates make it easy for corporations to borrow cash to finance growth. Corporate interest payments will be low, making profits higher. This is all to say that all else equal if interest rates are high, stock prices go down. If interest rates are low, stock prices go up.
International Sales
A second fair criticism of the Buffett Indicator is that the stock market valuation reflects international activity while GDP does not. Though GDP does include national exports, it would not include something like the sales Amazon makes in India (sourced from Indian fulfillment centers and sellers). However, Amazon's India business is definitely priced into its overall stock price, which is listed in the USA. Imagine if the Indian government banned Amazon from the country and shut down all its operations/subsidiaries there. This would lower Amazon's stock price, which would lower overall US stock market value, but have no impact on US GDP. That is, the Buffett Indicator would fall. Globalization has expanded steadily over the last 50 years and has been a key driver in the growth of the Buffett Indicator over time, since US stocks have risen in value due to overseas activities not included in US GDP.
Conclusion
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, or that the profitability of US companies has structurally increased, 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.
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