Buffett's Favorite Market Indicator
Total Stock Market to US GNP ratio
The Total Stock Market cap divided by the US GNP is a long-term valuation indicator for stocks. Back in 2001 in an interview in Fortune Magzine Warren Buffett put this indicator on the map as he stated that this is probably the best single measure of where valuations stand at any given moment in time. The Wilshire 5000 Index is one of the broadest benchmark index for the U.S. equity market. The objective is to capture the total market capitalization of most of the publicity traded companies in the U.S. The original indicator has some drawbacks as the data being published is on a quarterly basis and as such tends to lag. Nonetheless, since the data dates back to the 1940s is a lot of information allowing for in-depth and historical trend analysis.
Fundamental Valuation Premises
Many of the fundamental based market indicators that evaluate a gauge of the long-term returns of the stock market is based on the following premises:
(1) Interest Rates – the direction of interest rates impacts financial valuations. As interest rates rise, the prices of all other investments tend to adjust downward. On the other hand, as interest rates decline, this helps many assets including stocks upward.
(2) Long-term Growth of Corporate Profitability – corporate profitability tends to return to its long-term historical norm. In the US it has been around 6%. During recessions, corporate profit margins tend to contract and during economic expansion cycles, it tends to expand toward its long-term economic growth rate.
(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.
Current Total Stock Market cap to US GDP
The current Total Stock Market cap to US GDP has now climbed toward an all-time high of 175.9% (Aug 2020). 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 a 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 159.2 (Dec 1999) just ahead of the Tech/Telecom dot.com bubble. So, given the current high readings in this indicator does this imply the US stock market annual returns going forward will be much lower and possibly negative in the future?
This remains a challenging question as there are a number of major developments that may lead to structural trend changes and hence a change in valuations in the marketplace. These developments include: (1) a historically low-interest-rate environment in the U.S. and negative interest rates overseas. As the US and global interest rates remain stubbornly low hovering near-zero does this lead to even higher valuations for the US stock market; (2) the fourth technology revolution and the proliferation of technology disruptors, and recently the acceleration of the stay at home technology trend. Can this new market paradigm translate into higher valuations than normal? and (3) the enormous growth and massive inflows into passive and index-based investment vehicles appear to be structural in nature. Do the strong money flows into passive investments push the stock market and valuations to even higher levels?
Technical Ratio Analysis Indicator
From a technical perspective, ratio analysis is one of the best technical measures to determine the relative performances of two securities as well as to quantify overbought and oversold market conditions. Attached is the Wilshire 5000 Composite Index (WLSH) divided by the US GDP and the monthly chart of the Wilshire 5000 Composite Index (WLSH).
Wilshire 5000 Composite Index/US GDP Ratio Analysis
WLSH/US GDP ratio has risen from its 2009 market bottom when it was trading from a reaction low of 0.555 to a current ratio of 1.42. In the process, it has surpassed the 2000 market peak ratio of 1.399 and has also cleared above the 2018/2019 highs of 1.485/1.447. In fact, the WLSH to GDP ratio recorded an all-time time of 1.577 in Jan 2020. Although an overbought market condition has developed, we would not be surprised to see the ratio retest 1.577. The pertinent question is whether the ratio can establish new all-time highs. If this occurs then does this reaffirm a new paradigm shift in the marketplace toward even higher levels (valuations) driven by historically low-interest rates, secular growth of Technology, and/or the continued massive inflows of passive and indexed based investments. It is also interesting to point out the 10-plus year bull market rally in the Wilshire 5000 Composite Index (WLSH) closely resembles that of the WLSH/GDP uptrend. Both show a well-defined 10-plus year uptrend channel. Will a breakout above 1.577 (Jan 2020 highs) in the ratio signal a test of the top of its uptrend channel at 1.82-1.84? At this level does this also translate to WLSH trading to the top of its 10-year uptrend channel now at 39,000.