Is there any human whose market wisdom is more closely followed than Warren Buffett?
He is the undisputed king of value investors. His company, Berkshire Hathaway, is one the largest in the world, and it has made him one of the richest. Berkshire’s book value and market value have grown at ~20% per year since 1965, compared to just 10% per year for the S&P 500 (and that includes dividends!).
Buffett’s basic value investing criteria for a company are fourfold:
- One that we can understand
- With favorable long-term prospects
- Operated by honest and competent people and
- Available at a very attractive price
Among Buffett’s other investment metrics, a lot of attention is paid to his Valuation Indicator, which bears upon the last of the above. There are times when lots of companies are available at attractive prices, and times when few are. It pays to be able to tell the difference.
Buffett once remarked in an interview that the Indicator “is probably the best single measure of where valuations stand at any given moment.” It doesn’t have a huge sample size—it’s only been around since the mid-20th century—but it’s proven to be highly predictive of where the overall market is headed, as opposed to individual stocks.
The Indicator is a simple calculation that anyone can make: the ratio of a country's stock market capitalization to the overall gross domestic product of the country expressed as a percentage. Is GDP a higher number, and by how much? And vice versa.
If the stock market is below 50% of GDP, Buffett believes it is very undervalued on a relative basis. Between 50% and 75%, it is somewhat undervalued. Between 75% and 90%, it is in the Goldilocks Zone—just about right. From 90% to 115%, it is overvalued. And above 115%, it is extremely overbought and a reversal should be expected.
Not that there are not anomalies. Of course there are. A trend in motion can continue on in that direction long past the point where there “should have been” a correction. As the old saying goes, the market can remain irrational longer than you can remain solvent.
For example, a buying frenzy commenced with the end of the stagflationary bear market of the late 1970s and early 1980s. Beginning with the bottom in ’83 (Buffett Indicator = 32%), the market went on a historic tear, rising with just occasional moderate setbacks for the next 17 years. It peaked in 2000, just as the dot.com crisis was about to hit (Buffett Indicator at the nosebleed level of 151%).
After that, the Indicator crashed mightily, bottoming at 68% in ’03. It rose to 110% in ’07, before the Great Recession took it down to just below 60% in ’09, as you can see in this chart of the S&P 500’s nominal value divided by GDP.
The current recovery, and concomitant bull market in stocks, is now in its tenth year. That’s meant smooth sailing for the Buffett Indicator, which has enjoyed a pretty steady rise, sailing through both the Goldilocks Zone and the area of moderate overvaluation.
Today it stands at around 144. Lower than the 2000 peak, but nevertheless a dangerous level.
Here is the Indicator charted against economic recessions:
(For those who wonder, the numerator in the chart title, MVEONWMVBSNNCB, is the Fed’s fancy title for the S&P. Again, the denominator is nominal quarterly GDP.)
As you can see, the Indicator tends to start dropping just before a recession starts, and usually starts trending up before the recession ends.
If you chart GDP against the broader Wilshire 5000, the Buffett Indicator is even higher.
So… where are we now? Are we in the midst of another 17-year uptrend? Or at one of those inflection points that signal a reversal on the way?
Good question. The Buffett Indicator is either close to its all-time high (S&P) or already past it (Wilshire). History suggests that a tumble should be at hand. But you never know. Perhaps this time the Indicator will blow by its former peak into uncharted territory.
You’d think that The Man Himself might have the answer.
But Warren Buffett has never been one to make predictions. Except for this: think long term.
“America,” he said in an interview earlier this year, “is a powerful economic machine that, since 1776, has worked and it’s gonna keep working…
“You don’t want to buy to hold for a year. You don’t want to buy with the idea that you could sell it in two years or three years and make money. You could lose money that way. But if you buy [the stock market] and just keep buying the S&P 500 and forget about all the other nonsense that’s being sold to you … you’re going to do well.”
In June 2018, with his own Indicator clearly flashing red, he seemed to contradict it. He was very bullish. “Right now,” he said, “there’s no question: [the economy] is feeling strong. I mean, if we’re in the sixth inning, we have our sluggers coming to bat right now.”
Given Buffett’s analogy, if we’re in the sixth inning of a baseball game, then the ninth is still four to five years distant. That means the economic expansion would continue into 2022 or ‘23.
Well, we’re skeptical. That’s quite a stretch, and it means a lot of things have to go right.
It means that the major beneficiaries of the Trump tax cuts would have to focus on increasing shareholder value (perhaps through buybacks, at the expense of growing their businesses). It means that the Fed will have to increase interest rates at a slower rate than expected, if at all. It means that tariffs or an all-out trade war don’t decimate the economy. And it means sufficient wage growth that consumers don’t feel impelled to tighten their belts too much.
It’s a lot to ask for, and it’s why the Sage of Omaha’s time frame is long. “I’m no good at predicting out two or three or five years from now,” Buffett says. “America’s going to be far ahead of where we are … 10, 20 and 30 years from now.”
Which is fine if you have time for that kind of perspective. But many of us don’t. In contrast to Buffett, the National Association for Business Economics—in its most recent quarterly outlook—echoed the feeling of many market watchers. The NABE found that among its economists, 2/3 believe a recession will arrive by 2020, and 18% think it will hit as early as next year.
For those for whom a 5-year outlook is very important—and who can’t afford a large, short-term haircut—they may well be best served by paying more attention to Buffett’s Valuation Indicator than to his words.
Contrarian and data-driven investors that we are, we remember what happened the last time the market was this overextended. Peak to trough, the Nasdaq as a whole lost 78% of its value.
We’ll explore more of these telltale market gauges in the coming weeks. But the time to act, if you need to right-size your gold allocation for the correction to come, is right now.
Open an account today and in minutes you can have your strategic “stock-market insurance” in place with just a few clicks.