Buffets Favorite Market Indicator
Warren Buffett’s favorite market indicator is the Total Stock Market cap divided by US GNP. Buffett and many fundamental investors believe this is single best measure of where valuations stand at any given point in time. These investors believe the long-term returns of the stock market are based on three major premises:
(1) Interest Rates – the direction of interest rates impacts financial valuations. As interest rates rises, the prices of all other investments tend to adjust downward. On the other hand, as interest rates declines, this trend will push the prices of all other investments upward.
(2) Long-term Growth of Corporate Profitability – over the very long-term corporate profitability tends to return to its long-term historical trend. In the US it has been around 6%. During recessions corporate profit margins tend to decrease. During economic expansion cycles it tends to expand toward its long-term economic growth.
(3) Market Valuation – over the long term, stock market valuation also returns to its historical mean. A higher current valuation will lead to a lower long-term return in the future. A lower current valuation will lead to a higher long-term return in the future.
The current Total Stock Market cap to US GNP has recently climbed to an all-time high of 156.5%. For reference, a ratio of less than 50% denotes a significantly undervalued US stock market. Between 70% and 75% is a moderately undervalued market. Between 75% and 90% is fair valued market. Between 90% and 115% is a moderately overvalued market and a ratio greater than 115% is a significantly overvalued market.
Based on the current reading this would imply the US stock market is trading at overvalued levels. The lowest was about 35% during the height of the double dip recession in 1982. The highest reading was during the Tech/Telecom bubble in 2000. So, given the current high readings in this indicator does this imply that the US stock market annual returns going forward will be much lower and possibly negative in the future?
This is a difficult question to address as there are so many variables in play including an especially low historical interest rates in the U.S. and negative interest rates overseas. As global interest rates remain stubbornly low does this lead to even higher valuations for the US stock market. The fourth technology revolution and the many technology disruptors have also impacted the global economy. It has not only improved the overall productivity but also made the marketplace much more efficient. Does this translate into higher valuations for innovative disruptors across different industries and sectors? The enormous growth and money flows into passive and index-based investment vehicles appear to be structural. Do the strong flows into passive investments push markets and valuations to even higher levels?
From a technical perspective, ratio analysis is one the best technical measures to determine the relative performances of two securities as well as to quantify overbought and oversold levels. Enclosed below are two of broadest and most popular US stock market indexes including the Wilshire 5000 Composite Index (WLSH) and the S&P 500 Index (SPX) as they relate to the US GDP. We have briefly summarized our technical findings below:
Wilshire 5000 Composite Index/US GDP ratio analysis:
WLSH/US GDP ratio is currently trading at 1.42. This ratio has now surpassed the 2000 market peak ratio of 1.399. It is just within striking distance of its prior 2018/2019 highs of 1.49/1.45. WLSH to GDP ratio has been rising since 2009 market bottom when it was trading at reaction low of 0.555. Although an overbought market condition has developed, we suspect that it may become even more overbought in the future. It is also interesting to note that the 10-plus year bull market rally in US stocks (i.e., SPX) closely resembles that of the WLSH/GDP uptrend. Both shows a well-defined 10-plus year uptrend channel. Will a breakout above 1.45-1.49 (2019/2019 highs) send the ratio to a test of the top of its uptrend channel at 1.69-1.70? Will a failure to breakout here signal a peak in the US stock market bull rally?
S&P 500 Index/US GDP ratio analysis:
SPX/GDP ratio is currently trading at 0.14. Unlike the above ratio WLSH/US GDP ratio, which is trading at all-time highs, the SPX/GDP ratio is still trading below its 2000 high (0.1485) as well as below its Jan 2018 high (0.1433). The recent low is 0.0546 established during 2009 stock market bottom. The extreme low remains at 0.0312 coinciding with the bottom during the double dip recession of 1982. It appears that based on the SPX to GDP ratio as compared to the WLSH to GDP ratio the SPX Index is relatively cheaper than the broader based Wilshire 5000 Index. An impending test of its prior highs at 0.1433-0.1485 will likely decide the fate of SPX. A convincing breakout suggests a rally toward 0.1672 or the top of its uptrend channel. Will this rally lead to even higher SPX prices before the start of the next major SPX correction (15-20% plus) or worse, the beginning of a bear market decline? On the downside, a convincing violation of the bottom of its uptrend channel (0.1248) and its 2019 reaction low (0.1158) can also warn of a major trend reversal possibly signaling a stock market peak and the start of the next deep market correction or worse, the beginning of the next bear market decline.