Buffett Indicator Says Markets Will Crash?

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“The “Buffet indicator” says the stock market will collapse. This was an email I received recently and was worthy of more detailed discussion. Let’s start with my favorite line from “The Princess Bride.”

“I do not think it means what you think it means.

The Buffett Indicator is a valuation measure that compares stock market capitalization to gross domestic product. One of Warren Buffett’s favorites, the Indicator it is less than 2.44 times the market capitalization of GDP. That number doesn’t mean much by itself, but it strikes when placed in a historical context. Even after the recent decline in markets, the ratio is still one of the highest on record, north of the 2.11 level recorded during the dot-com bubble. 2000and significantly higher than the average since 1950.

market capitalization / GDP ratio adjusted for inflation

Since 2009, repeated monetary and zero-rate policy interventions have led many investors to reject any measure “assessment.” The reasoning is that since there was no immediate correlation, the indicator is wrong.

The problem is that valuation models are not, and never should have been, market timing indicators “. The vast majority of analysts assume it is a valuation measure (P / E, P / S, P / B, etc.) reaches a certain level, it means that:

  1. The market is about to collapse and;
  2. Investors should be 100% cash.

That is not correct. Valuation measures are just that: a measure of current valuation. More importantly, when valuations are excessive, it is a better measure “investor psychology” and the manifestation of the “theory of the great fool”.

What the valuations provide is a reasonable estimate of long-term investment returns. It makes sense that if you overpay for a future cash flow today, your future return will be low.

Why the Buffett indicator is valuable

Although often overlooked, the Buffett indicator tells us as much as it measures “Market capitalization” to “GDP”. To understand the relative importance of the measure, we need to understand the business cycle.

Buffett indicator

The premise is that in an economy that is about 70% driven by consumption, individuals must produce in order to have a salary to consume. That consumption is where companies derive their revenues and ultimately profits. If something happens that leads to lower production, the whole cycle reverses, leading to an economic contraction.

The example is simplistic, as many factors affect the economy and markets in the short term. However, economic growth and corporate earnings have a long-term historical correlation. Therefore, although it is sometimes possible for earnings to grow faster than the economy, for example after the recession, they cannot outrun the economy indefinitely.

YOGA growth

Since 1947, earnings per share have grown by 7.72% annually, while the economy has grown by 6.35% annually. Again, the close relationship between growth rates should be logical. This is especially true given the significant role that spending plays in the GDP equation.

Therefore, the Buffett indicator tells us that overvaluation is not sustainable when the market capitalization of stocks grows faster than economic growth can support. Therefore, a market capitalization ratio (the price investors are willing to pay multiplied by the total number of shares outstanding) greater than 1.0 is overrated and less than 1.0 is undervalued. Today, investors pay nearly 2.5 times what the economy can generate in revenue and earnings.

Does this over-valuation mean that the stock market will collapse? No.

However, there are significant implications that investors should consider.

Evaluations and returns at term

As always, while the ratings are terrible “Market timing” indicator, they are an excellent predictor of future returns. Earlier I mentioned Cliff Asness on this issue in particular:

“Ten-year forward average yields drop almost monotonously at the start of Shiller P / E rise. Also, as Shiller’s initial P / E increases, the worst cases get worse and the best cases weaken.

If today’s Shiller P / E is 22.2 and your long-term plan calls for a nominal return of 10% (or with today’s inflation of around 7-8% real) on the stock market, you’re basically rooting for the absolute best case in history coming up and cheering for something drastically above the average case from these ratings. “

We can demonstrate this by looking at 10-year total returns ahead of various levels of P / E ratios historically.

10-year forward real yields

Asness continues:

“It [Shiller’s CAPE] it has very limited use for market timing (certainly on its own) and there is still a great deal of variability around its predictions even for decades. But if you don’t lower your expectations when Shiller’s P / E is high for no good reason – and, in my opinion, this time the critics have not provided a good reason – I think you are making a mistake. “

And since we’re discussing Mr. Buffett, let me remind you of one of Warren’s more insightful quotes:

“Price is what you pay, value is what you get.”

The “Buffet Indicator” confirms Mr. Asness’s point. The chart below uses the Wilshire 5000 market capitalization versus GDP and is calculated on quarterly data.

Buffett indicator versus 10-year returns

Not surprisingly, like any other valuation measure, forward return expectations are substantially lower over the next ten years than in the past.

Fundamentals don’t matter until they do

In the “Heat of the moment,” fundamentals don’t matter. As mentioned, they are poor timing indicators.

In a market where momentum is driving participants due to the “Fear of getting lost (FOMO)” the fundamentals are replaced by emotional bias. Such is the nature of market cycles and one of the primary ingredients needed to create the right environment for a potential turnaround.

Notice, I said at the end.

As David Einhorn once said:

“The bulls explain that traditional valuation metrics no longer apply to certain titles. Longs are confident that everyone else holding these stocks understands the dynamics and won’t even sell. With holders reluctant to sell, the shares it can only go up – seemingly to infinity and beyond. We have already seen it.

There it wasn’t a catalyst we know that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top and it is difficult to predict when that will happen ”.

Also, as James Montier previously stated:

Current arguments as to why it’s different this time around are masked by the economics of secular stagnation and the workhorses of standard finance like the equity risk premium model. While these may lend an appearance of respectability to those dangerous words, taking arguments by face value without considering the evidence seems to me, at least, to be a common link with the previous bubbles.

Stocks are anything but cheap. Based on Buffett’s preferred valuation model and historical data, return expectations for the next ten years are likely to be as negative as they were for the ten years following the late 1990s.

Investors would do well to remember the words of then SEC chairman Arthur Levitt. In a 1998 speech entitled “The numbers game” he has declared:

“Although the temptations are great and the pressures strong, the illusions in numbers are just that: ephemeral and ultimately self-destructive.”

Regardless, there is a simple truth.

“The stock market is NOT the economy. But the economy reflects precisely what drives higher asset prices: earnings. “

No, the Buffett indicator does not mean that the markets will permanently collapse. However, there is a more than reasonable expectation of disappointment for future market returns.

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Editor’s Note: The summary bullet points for this article were chosen by the editors of Seeking Alpha.

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