Buffett Valuation Model Indicates Stock Market is Overvalued by Jaimini Desai, Amigobulls

Warren Buffett is known for his value investing discipline, which eschews bold calls on market direction in favor of analyzing individual companies. Many passive investing advocates use this to claim that any sort of macroeconomic analysis is a violation of Buffett’s core philosophy. However, this is undercut by some of Buffett’s best work, whether it is in his investment letters or his public statements on whether general markets are over or undervalued.

Two of the most famous examples are his “Buy America” letter he published in the New York Times at the height of the credit crisis in October 2008 and his deconstruction of the exuberance in technology stocks during the tech bubble. In both of these cases and through his investment letters, Buffett has explained his crude valuation model for the entire stock market in the form of one ratio – comparing total market cap of the stock market to GDP.

As Buffett has stated, this is far from a precise timing tool, but it gives a rough idea to investors when the overall market is expensive or cheap. Historically, Buffett’s most aggressive acquisitions have come when GDP is greater than the total market cap of stocks. When the overall market capitalization eclipses GDP, the market is considered expensive, and future returns will be diminished, as the market becomesmore overvalued. Of course, the opposite is also true.

With the stock market recovering from its nearly 10% correction from the end of September and beginning of October by furiously rallying to new highs in two weeks time, it is an apt time to check in on Buffett’s indicator. Given the violent and relentless surge higher, once again animal spirits are prevalent on Wall Street. Having some sort of objective valuation tool is an effective countermeasure to emotional impulses that can wreck portfolios.

Currently, the stock market is quite expensive, based on Buffett’s indicator which he described as “probably the best single measure of where valuations stand at any given moment”. In fact, it is at the highest level since the euphoria in 1999-2000. Below is a long term chart of the measure compared to the S&P 500:

Warren Buffett Valuation Model

Warren Buffett Valuation Model

credit: vectorgrader.com

The current total market cap of the stock market is 127% that of GDP. Some of the best long term entries in stocks have come when this measure is depressed such as in 2003, 2008-2009, and the early 90s and 80s. The purpose of this exercise is to help investors determine whether fundamentals are keeping up with the stock market’s advance or whether investors are getting ahead of themselves.

The takeaway from this chart is quite clear. Prices have gotten too far ahead of fundamentals; therefore this is not a good point for long term entries. Now someone bullish on stocks may argue that this is a “new normal” given the low interest rates pledged by the FOMC and central banks all over the world. Thus, this circumstance has rendered traditional valuation tools, obsolete. Many Wall Street strategists are actually using that same logic to justify their continued bullishness on stocks.

One common aphorism in financial markets is “this time is different”.Whenever one hears this, it is wise to slowly back away. The primary reason for the stock market’s tendency over long periods of time to constantly migrate from extremes of fear and greed is human nature. While technology, institutions, and attitudes may have changed to an extreme degree throughout human history, human nature still has not. And these same emotions which evolved in this manner because they were so useful for survival can be an investors’ worst enemy when it comes to properly timing entries and exits.

Humans are wired to follow the herd, but exceptional, long term outperformance in investing requires one to be a contrarian at the turning points. It requires pessimism when everyone is excited about their stocks, watching their portfolios climbing higher, and optimism when everyone is depressed about the stock market to the point that no one wants to even talk about it. Additionally, being a contrarian is only rewarded at turning points, so blindly betting against the crowd is a quick way to lose principle on investments. Of course, it is easy to describe such behavior; however, it is infinitely more difficult to apply it on a consistent, daily basis.

The difficulty of managing emotions is exemplified by the rarity of Buffett’s success and the relatively few in his class who have managed to consistently outperform the market. This is why Buffett always stresses the importance of emotional discipline when it comes to earning outsized returns. The total market cap to GDP ratio is one tool in his toolkit to not let price action sway emotions.

Given the current, unique structure of the market – major averages at all-time highs but signs of distribution underneath the surface – it is an appropriate time to borrow and apply this measure from Warren Buffett. At this moment in time, Buffett would be preaching caution. Now, there is no causality in this ratio, meaning things will not start going down because it is overvalued, and trades on the long side should still be considered. However, it stresses the point that there is currently more risk on the long side, and in terms of indices, returns will be depressed going forward.