The Buffett Indicator
The Buffett indicator is a metric that Warren Buffett proposed in 2001, which takes the market cap of the index and divides it by the annual GDP.
Please note that any information supplied on this website is for entertainment purposes only and should not be taken as financial advice. Any reader should do their own research and/or consult with a qualified financial advisor.
For instance, as of November 30th, 2023, the current US stock market is 48.41 trillion dollars and the annual GDP is 27.7 trillion dollars. When divided, the ratio is around 1.75. If we were to map out this ratio through time, the median value would be around 0.79.
The typical range that this value floats in is between 1.18 and 1.66. All this suggests that the current market is significantly overvalued and that returns will be lower over the next 10 years.
There are limitations to this metric, but ultimately, the Buffett indicator seems to held up particular well when the stock market index in question is large.
There have been some attempts to correlate significant market declines or crashes to the indicator, but it is certainly not foolproof; 7 out of the last 14 downturns (market drops of 10% or more) have not been predicted by the indicator.
Is Indexing Going to Yield a fair return?
Historically the US stock market has provided investors with a significant average return of over 10%.
However, with the Buffett indicator such significant overvaluation, is there any reason to assume that these historic returns will continue in the same vein?
There are three factors which significantly affect our understanding of whether these returns will continue:
- The dynamism of the global economy and the strength of emerging and developing economies
- The effect of automation and AI on the returns that can be produced for shareholders (this could involve both negative and positive effects)
- The local US economy’s resilience and other political events
Please note that any information supplied on this website is for entertainment purposes only and should not be taken as financial advice. Any reader should do their own research and/or consult with a qualified financial advisor.
The Global Economy
As the companies that make up the US stock market are so international, the US economy’s growth is inevitably tied to the fortunes of other large economies. For instance, a recession in Europe or China, invariably impacts upon the fortunes of US companies.
Although there are many issues that will affect many developing economies, I still believe that there is significant room for growth and that markets have the potential to widen over time.
Automation and AI
There are good reasons to assume that the effect of AI and automation on the way that companies run their operations will be significant. This may, however, might also lead to disruption of employment and other effects that are less than positive.
I also think that many of the rich valuations in the stock market are afforded to companies which are in that fierce AI race such as Nvidia, Microsoft, etc.
If your were actually to remove the big 7 from the S&P 500 index, the average PE ratio would be around 15. The magnificent 7 actually trade at an average PE ratio of 41 times.
It is true that prospects for the magnificent 7 are quite exciting moving forward, as they are on that tech wave, however, there are probably a lot of companies with lower valuations that provide great opportunities for long-term growth, which have been affected in the short term by high interest rates.
Also, the benefits of AI and automation will be felt in industries which are not necessarily synonymous with “tech”. For instance, the food industry, construction, finance, etc. I believe that the fact that there are large asymmetries in the stock market actually creates opportunities for the discerning stock picker.
This is one of the reasons that I have concentrated my investments recently on REITs (but very selectively) which have come down significantly in valuation with the rise in interest rates. Moreover, the dividend income is a great comfort.
I believe these drops in valuation have in many cases, been overblown.
Resilience of the US Economy
Naturally, these companies in the S&P are still reliant on the US growth.
There are many commentators who have pointed to the likelihood of a US recession occurring over the next year, which will, of course, curtail growth and affect the valuations of companies. Inversion of the yield-curve is also a flashing indicator of recession.
However, I believe that a recession will likely be short-lived, and will provide an ideal opportunity to buy companies at lower valuations.
For now, it is perfectly possible to pick individual stocks at fair prices, despite valuations being quite stretched.
Conclusions on the Buffett indicator and valuations
If you’re already averaging into a market over time, continue doing so, as you should do fine over the long term. Remember that investing success is, in large part best pursued with a mindset of consistency. Most people who average into the market, outperform people who trade in and out of the market.
You should expect, however, that returns over the next 10 years will be significantly affected by the current levels of overvaluation. Charlie Munger certainly echoed this sentiment.
“So many people are in it, the frenzy is so great and the reward systems are so foolish. I think the returns will go down”
Munger
However, if you are an individual stock picker, try to take advantage of the fact that many companies have negative sentiments weighing them down.
In some cases this is completely justified, however, there are definitely some opportunities out there for the investor who is willing to invest time into adequate research.
