The Flaws in Buffett's Favorite Stock Market Indicator.
During a 2001 interview with Fortune magazine, famed investor Warren Buffett commented on his favorite stock market valuation indicator, calling it "probably the best single measure of where valuations stand at any given moment." With his comments, the oracle of Omaha propelled the market-cap-to-GDP ratio to center stage, increasing its popularity almost overnight. Was he correct? Is this a reliable indicator of stock valuations? I do not believe it is correct, and here's why.
To calculate the valuation of the U.S. stock market using this indicator, you simply divide the total market cap of all publicly traded U.S. stocks by GDP. The rationale behind it seems sound. After all, stock prices are based on profits, and corporate profitability is connected to economic growth. Therefore, if the economy expands, it is reasonable to assume that corporate profits will rise and push stock prices higher. However, if stock prices expand at a faster rate than the economy, stocks will become overvalued. Here is an overly simplified example to provide clarity.
Assume there are 1,000 publicly traded companies in the U.S. When you multiply the number of outstanding shares of each company by their price, the total market cap is $1.0 billion (i.e., the numerator). If GDP is also $1.0 billion (the denominator), the ratio would be 100% ($1.0 billion / $1.0 billion), indicating that stocks are fairly valued. Now let's assume it is 12 months later and total stock market cap has risen to $1.5 billion. If GDP remained at $1.0 billion, the ratio would be 150% ($1.5 billion / $1.0 billion). Hence, stocks would be 50% overvalued. It's that simple, but there are some major flaws in the formula.
To understand where the tool falls short, we will examine a graph of the indicator's market valuation from December 31, 1970 to August 4, 2016. The red-dotted line indicates "fair value," the point when stock market cap and GDP were equal.
Let's look at three points. First, when the 1973-74 bear market began, the indicator was near 85%, showing stocks were 15% below fair valuation. Next, when the greatest single-day percentage decline hit the market in 1987, the indicator was below 70%; so stocks were undervalued by over 30%. Finally, when the financial crisis struck in 2007-08, stocks were only slightly overvalued. Why did stocks experience such a significant decline if they were not that overvalued (2008) or when they were extremely undervalued (1973-74 and 1987)? Perhaps other factors caused the declines, such as the housing crisis in 2008 or program trading in 1987. Perhaps the indicator is just not that reliable. Here are a few possible reasons for its lack of accuracy:
1) Many large U.S. companies derive a significant portion of their revenue overseas (i.e., from economies outside of America). As globalization continues, the formula's denominator (U.S. GDP) will become less meaningful.
2) The number of U.S. publicly traded companies and total market cap have risen, which may distort the numerator.
3) Company buybacks have increased, thus reducing the number of outstanding shares and market cap.
It is likely there are more reasons behind the indicator's erroneous readings. Even if you deem it worthy, remember stocks can remain overvalued or undervalued for a prolonged period before reversing course.
Buffett may be correct in that the indicator may be the "best single measure of where valuations stand at any given moment." But this may be a relative assessment and there may not be any better alternatives.
If you decide to rely on it, given its history, I would do so with caution.