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.
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.
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.