The modern growth of global stock markets instills a certain optimism in most retail investors. At the same time, many understand that a bull trend cannot last forever and begin to pay attention to forecasting tools that allow them to predict the onset of a correction or market reversal. Among others, analysts and experts increasingly mention the so-called “Buffett Indicator.”
What is the Buffett Indicator?
The Buffett Indicator is an invention of the “Oracle of Omaha,” who modestly describes it as “the best and only indicator of the true market valuation at any given moment.” According to the investor, his calculation method can provide a fairly accurate representation of the real undervaluation or overvaluation of a country’s stock market as a whole.
The “Buffett Indicator” is calculated as the ratio of the market capitalization of all public companies to the country’s GDP. New values are determined quarterly after the release of revised quarterly GDP reports or annually.
The first of the indicators is determined:
- From the balance sheets B.103 of American companies, which are publicly available on the website of the regulator – the Federal Reserve System.
- From the current (at the time of publication of revised quarterly or annual GDP data) values of the broad stock index Wilshire 5000.
Warren Buffett himself used the first option, which allowed him to construct a curve over almost an 80-year period. When working with the Wilshire 5000, it is impossible to obtain an analysis over such a time span, as the index has only been calculated since 1971.
The difference in data gives a negligible margin of error in values (the discrepancy does not exceed 0.5%), while the behavior of the indicator remains virtually unchanged.
How to Interpret the Values of the Buffett Indicator?
From a practical perspective, the Buffett Indicator serves as a kind of analog to the standard price-to-sales (P/S) ratio on a national scale. However, even with this approach, there are certain challenges in interpreting its readings. When evaluating the stocks of companies, the indicator is typically compared to the industry average or values calculated for competitors. For a country, however, it is almost impossible to find an adequate benchmark.
Analysts working with the Buffett Indicator use several methods to interpret its readings:
- Absolute values. In this case, under- or overvaluation of the market is assessed by the current value falling within a certain range:
- Less than 73% – the market is significantly undervalued, seen as a good buying opportunity for securities.
- 73%-93% – slight undervaluation. Consider buying opportunities, but conduct thorough analysis to find the best assets.
- 93%-113% – fair valuation. When selecting assets for purchase, other fundamental analysis indicators for the economy, industry, and specific company take precedence.
- 114%-135% – moderate overvaluation. The market approaches the zone of dangerous overheating, but it is still possible to find attractive assets for purchase.
- Above 135% – the “red” zone, the market is significantly overvalued, and the likelihood of a correction increases substantially. Investors should consider restructuring their portfolios by increasing the share of defensive assets or withdrawing investments into cash.
- Current value exceeding the average value for the entire calculation period. In this case, a negative difference of 30% or more is considered to indicate that the market is seriously undervalued, while a positive difference within the same range indicates significant “overheating.”
- Comparison with a trend line (usually a simple moving average) based on historical index values. In this option, the difference is not just assessed, but compared with the standard deviation. A range from -1 to 1 standard deviation is considered normal market condition, where options for buying and selling assets can be evaluated based on other indicators. When moving beyond the standard deviation, especially approaching -2 Std and 2 Std, it is said that the market is significantly undervalued or overvalued, prompting consideration of withdrawing investments into cash or transferring them to safer assets.
Despite different approaches to decoding the readings of the Buffett Indicator, successful and unsuccessful forecasts of market behavior coincide in all cases.
How Reliable is the Buffett Indicator?
Warren Buffett himself calls this indicator one of his favorites and claims he uses it extensively in his investment strategy. According to the Berkshire Hathaway owner, working with this index has helped him avoid many serious losses. “Be cautious when others are greedy,” he says, referring to the peaks on this indicator’s curve.
Analysts who closely study the Buffett Indicator highlight two notable predictions made with its use:
- The Great Depression of the 1920s. Based on historical data, the indicator formed a peak in the “red” zone of an overheated market even before the stock market crash.
- The Dot-com Crash in 2000. Around this time, all versions of the Buffett Indicator charts displayed local highs in the overvalued market zone, occurring several months before the crisis actually began.
The Buffett Indicator also gave confident growth signals, such as in 1982 and 2009. In the first instance, the upward trend continued almost until the dot-com crash in 2000, and in the second, it has continued to this day.
One of the biggest misses of the Buffett Indicator’s supporters is considered to be its lack of a warning signal before the market became overvalued ahead of the 2008 financial crisis. At that point, the indicator only slightly exceeded its average value.
One of the skeptics’ main arguments is the variation in the indicator’s values due to different approaches to calculating GDP. For instance, the St. Louis Fed’s Buffett Indicator value for 2000 (dot-com crisis) was 113%, Wilshire Associates put it at 138%, while Buffett’s original method showed nearly 160%.
These issues fuel analysts’ skepticism toward the indicator’s readings today, as it regularly hits new historical highs, exceeding 236%. They also have an additional strong argument: the Buffett Indicator does not account for the conditions of other markets.
This primarily refers to the bond market. Today, bond prices are at historical lows, while Treasury yields are steadily increasing. Furthermore, the Fed’s interest rates remain near zero, making borrowed funds extremely cheap for companies. Additionally, there is an active capital flow from bonds into stocks. This trend is linked to the current stock market rally, with claims that, if the situation continues, the growth will also persist.
Buffett and his team seem to believe in their indicator’s readings — Berkshire Hathaway’s cash reserves have reached an all-time high, and Buffett himself has remarked that there are no good companies left to buy at a reasonable price in the U.S. market.