What Exactly Is The Warren Buffett Indicator?

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Article by Vintage Value Investing

Warren Buffett is one of the most esteemed and revered investors of all time.

His investing prowess has led him to become the richest person in the world (at times) and one of the top 5 today. He is known around the world for his sound principles which have led him to invest in a number of growing companies in sectors such as insurance, transportation, consumer goods, energy, financials and other areas. Buffett’s Berkshire Hathaway corporation is now one of the largest firms on the planet.

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Among the many principles that Warren Buffett has espoused, his Buffett Indicator is one of the most important. This indicator can be used to help decide whether to invest in a country’s stock market.

What is the Buffett Indicator?

Simply put, the Buffett Indicator is the ratio of a country’s stock market capitalization to the overall GDP of the country.

The GDP (or gross domestic product) is the sum of all the exchange of goods and services in a country in a single year. In the US that number is about $19 trillion. The stock market is currently capitalized around $26 trillion. That is the sum of all the company valuations on the major stock markets. If the ratio is too low, the market will rise. If it is too high, the market will fall. This extremely simple indicator is not to be used for a single day or month but is a way of forecasting the market over a number of years.

Warren Buffett Indicator

Source: Advisor Perspectives

The theory is that if the total market capitalization is too low, the excess capital in the economy will fill the gap and prices will rise. The country is fundamentally rich enough to afford more investments in the stock market and the prices of these securities will rise. In contrast, the stock market price is too high when the GDP is relatively low. The economy is not well off enough to support continued investments in the stock market at the price levels. Underlying this theory is that the stock market is a reflection on the ability of the economy to produce cash and returns for investors.

Overvalued vs. Undervalued

To be more concrete, if the stock market is below 50% of the GDP, it is way too low. If it is between 75% and 90% of the GDP, the market is about right. If the stock market capitalization is above 115%, it is overvalued on a relative basis. Unfortunately, in late 2017 the market is over 130% of the GDP. This means that the market is relatively overvalued.

Does this mean the market will crash? Absolutely not. According to Buffett, the market does not need to crash or rise dramatically to accord with his indicator. However, over the long term the stock market returns will tend to even out. At this rate, the market is expected to return -1.5% per year over the next ten years according to the Buffett Indicator. It’s also worth noting that relative to other investments like fixed income, the stock market could still be considered relatively cheap or at least fairly valued.

How to Use the Buffett Indicator

Rather than ringing an alarm bell, an investor has several ways to deal with this problem. First and foremost, they can use the same indicator to identify countries that have undervalued stock markets. They can easily buy the indexes of those countries and expect decent long-term returns. There are several countries in Asia and South America that still have way undervalued stock markets.

Secondly, investors can take the principles of the Buffett Indicator and narrow them down to individual sectors or companies. Perhaps there is a company that is issuing a much higher amount of dividends then its peers. This firm is likely to rise in value.

Similarly if one sector of the economy has a lower market value relative to its historical value, it is likely to rise. For example, currently the technology stocks are providing most of the stock market gains. So even though the market as a whole has been rising, certain sectors have lagged behind. Investors can identify sectors that are relatively lagging even though performance is good. These may perform better in the future.

 

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…