So the Buffett Indicator has been making the rounds again . It shows a wide divergence from US GDP and the total market cap of US stocks giving those who feel the market is overvalued ammo for their arguments. I’ve felt for some time the Indicator is no longer valid and recently has a back and forth with “Davidson” on it.
My thesis was that comparisons of market levels now vs history are not apples to apples comps. Why?
1- Profits margins are far higher now (and staying there) than they were 20,30 or 50 years ago. That means that a greater % of US GDP is falling to the bottom line of corporations than it has in the past. Since the market is based on earnings, that very fact alone means the market should be diverging from the GDP line. When GDP is growing ~3% annually and corp profits are growing 7%-10%, the two lines must diverge.
Here’s what Charlie Munger had to say at the Daily Journal meeting
Charlie Munger spoke at the Daily Journal Corporation's Annual Meeting of Shareholders today. Although Warren Buffett is the more well-known Berkshire Hathaway chief, Munger has been at his side through much of his investing career. Q4 2020 hedge fund letters, conferences and more Charlie Munger's speech at the Daily Journal meeting was live-streamed on Yahoo Read More
2- In addition to that, a greater percentage of US profits are coming from US firm’s production overseas. This production does not add to US GDP but the profits from them are reported by US companies and those profits are further rising the valuation of the US market vs US GDP. For instance, Apple’s iPhones and iPads are made in China and imported to the US. The value of their import subtracts from US GDP but their profits are reported by Apple and boost Apple’s stock price. The same holds true for other companies. It should be no surprise that as the US’ dominance in manufacturing has waned over the past several decades that what we are seeing in the Indicator is in fact happening. In fact ~50% of S&P 500 profits are from overseas vs ~30% just 20 years ago that is more than a little significant.
The Buffett Indicator issue is complicated.
First, the Buffett Indicator does not incorporate the right metrics. The correct metrics are long term SP500 earnings vs. long term GDP growth rate. My GDP growth rate is 3% RGDP + Inflation of 1.6% or 4.6% which when divided into long term SP500 eps gets us to $1,961 as a value for the SP500 historically. Today, not so over-priced.
Second, US GDP has been less than historical due to Fed keeping 10yr Treas rates well below where banks can lend profitably. This has stiffled housing. At some point investors will flee bonds (may be happening now) and we will see mtg rates rise to 5.5%-6% range and lending will soar taking housing on a big leg higher for 4yrs-5yrs till demand is satisfied. This will kick stocks into high gear and GDP growth could see 6%-7%. Yes, a big upward change.
With the Fed having kept GDP growth so low, the mkt cap to GDP while certainly not the best of indicators is well out of sync.
GDP will show substantial catch-up once mtg rates rise and housing kicks into high gear.
You only come to understand our present condition by historical study of our economy.
1) Market forces are stronger than the Fed over the long term. This means that investors will sell bonds and move to equities to chase returns as they always have once market psychology that stocks are safer than bonds takes over.
2) US has been through many a series of rule changes, but in the end the US free market has an inherent growth of 3% RDGP + Inflation today. The 2.5% pace we are seeing will not be able to be sustained. We will breakout to the upside through the shear strength of market forces which will overcome the Fed.
3) Net/net human desire to own a home, achieve the American Dream, improve one’s family standard of living and the desire for financial independence is the most important driver of economic activity. It will eventually break the Fed’s tight credit regime which is what low mtg rates actually represent.
Once 10yr Treas rates rise to 4% we should see 30yr Conv. Mtg rates at 5.5% and the housing market should be roaring again. The SP500 will reflect a much more positive investor market psychology and while over-priced continue higher till housing demand is fulfilled. My guess is 5yrs of increasing equity prices. When housing slows, it should be obvious to those who are looking. Most will be so enthusiastic that they will keep buying right through the next market peak.
Further he added:
It is the GDP growth rate which becomes the capitalization rate for SP500 ($SPY) avg earnings(long term)
The issue to recognize is that when we had high inflation back in the 1970s to early 1980s when this index was likely ‘discovered’ GDP due to high inflation was at 13-14%(RGDP grew 3.2% while inflation was at 10-11%, voila GDP at 13-14%).
Use this as a cap rate in the 1970s and you get P/Es 7-8 range. Today inflation is 1.6% while RGDP historical trend is ~3%. Voila, GDP comes in at 4.6% and market P/Es are still cheap at 18. A cap rate of 5% justifies a 20 P/E. Today’s market is priced 3x higher due to lower inflation!!! Here is your discrepancy.
By making a false comparison between SP500 Mkt Cap and GDP value one simply misses the entire point. Buffett made a mistake in saying something about GDP and SP500 he did not correct later on.
The true comparison is between the historic trend of GDP growth rate (A rate used to capitalize cash earnings from alternative investments vs. the general economy) and the earnings coming from particular segments of the economy. Stocks are one segment which produces higher long term returns, i.e. 6.1% for the SP500, and you need the basic growth rate of your economy to price these returns.
One final point. I extend the RGDP trend forward at 3% even though we do not have 3% currently. This is primarily due to the Fed keeping mtg rates so low that the normal housing market has been stifled ($XHB). I expect this to eventually correct by the market overwhelming the Fed and forcing mtg rates to 5-6% range from the 4.2% today.
I am sticking with ~3% in my estimated RDGP going forward. Should the Fed be able to hold back RDGP by its mtg rate manipulation, then I will be forced to rethink where I think markets are likely to head. Obviously, if the Fed keeps GDP at where we are now, 3.5%, then such a low capitalization rate would justify markets much higher than I could ever have justified.
If we get a SP500 over $5,000 at its peak due to current Fed action to keep rates low, the correction will likely be more painful than any since 1990