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Buffett's Market Indicator Peaking?

Over the past month, Warren Buffett has accumulated a 14% stake in Occidental Petroleum (OXY). This week, Buffett acquired insurer Alleghany (Y) for $11.6 billion. Buffett seems to be actively putting his massive cash pile to work in the stock market.

With the uncertainties surrounding the Russia/Ukraine war escalating, inflation running rampant, and investors concerned about a policy mistake from the Fed, many are perplexed by Buffett's decision to reenter the stock market. A review of Warren Buffett’s favorite market indicator or the total US stock market cap to GDP ratio may offer insights into the market outlook.


The Buffett indicator takes the combined market capitalization of US stocks and divides it by the quarterly figure of the US gross domestic product (GDP). Buffett’s preferred market gauge has spiked to new historical highs. Does this imply stocks are overvalued and poised to decline?


US Total Stock Market to US GDP ratio


The Total Stock Market cap divided by the US GDP is a long-term valuation indicator for stocks. In an interview in Fortune Magazine in 2001, Warren Buffett stated that this is probably the best single measure of where valuations stand at any given moment in time. The indicator is a ratio of the US stock market and the US GDP. The FT Wilshire 5000 Index is a broad-based market capitalization-weighted index seeking to capture the total market capitalization of the publicly traded companies in the US. The original indicator has some drawbacks as the data is published every quarter, and as such, there are lagging tendencies. Despite this, there is relevant information on the US stock market and US economy dating from the 1940s, allowing investors for in-depth and historical analysis.


Fundamental Valuation Premises


Many of the fundamental based market indicators that value the long-term returns of the stock market relies 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 depreciate. However, as interest rates decline, assets such as stocks appreciate.


(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%. In 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, and a lower current valuation will lead to a higher long-term gain in the future.


Current US Total Stock Market cap to US GDP


As of today (3/23/22), the Wilshire Total Market Index is $44,925 billion. The last quarter's GDP is $24.01 trillion. The Buffett market indicator translates to 187%. A ratio of less than 50% suggests a significantly undervalued stock market. Between 70% and 75% is a moderately undervalued market. Between 75% and 90% is a fairly valued market. Between 90% and 115%, is a moderately overvalued market. A ratio greater than 115% is a significantly overvalued market.


A brief review of the Buffet indicator shows the US stock market is currently significantly overvalued. Based on the current level of valuation, many bears expect a stock return of -1.3% a year, including dividends.


Historically, the lowest reading is 35%, occurring during the height of the double-dip recession in 1982. The previous highest historic reading was 159.2 (Dec 1999), ahead of the Tech/Telecom dot.com bubble.


Based on the current new high ratio readings, does this imply future U.S. stock market annual returns will be much lower than their historic average? In a worst-case scenario, will it be negative returns?

With the ratio trading at all-time highs and interest rates still at historic lows, is it different this time?


The naysayers point to the following developments. Fed has pivoted toward a more restrictive monetary stance to fight inflation. Rising interest rates and drawing down the Fed sheet rebalancing can curtail liquidity and impact stock valuations. The supply chain bottlenecks continue to persist and do not show signs of abating. Inflation continues to soar to decade-high levels, eroding the value of stocks and increasing the risk for a Fed policy mistake and stagflation. The pandemic remains a viable threat to the health of the global economy. The economic recovery appears to slow, moving further from its mid-cycle expansion phase.

The optimists find relief in the following structural developments to suggest continued high valuations in stocks: (1)Interest rates remain historically low in the US and around the world. (2) Technology and innovation remain drivers of advances, job creation, productivity, and longer-term economic prosperity, leading to higher valuations for an extended timeframe. (3) The popularity of investing through index mutual funds and exchange-traded funds (ETFs) has grown substantially. Large inflows have changed market price dynamics and valuations. Does the money flow into passive investments sustain at the current torrid pace if the underlining indexes decline sharply?


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. It can identify overbought and oversold market conditions and trend changes. Wilshire 5000 Composite Index (WLSH) divided by the US GDP and the S&P 500 Index (SPX) divided by the US GDP are summarized below.

Wilshire 5000 Composite Index/US GDP Ratio Analysis


Wilshire 5000 Composite Index as a ratio of US GDP is currently trading at 1.99. The ratio has been rising since the 2009 market bottom when it traded at a low of 0.555. A breakout above the 2000 market peak of 1.399 in 2018/2019/2020 triggered a sharp rally to the top of its 13-year uptrend channel between 1.40-1.43 and 2.0-02.08. Although an overbought market condition can become more overbought, it is interesting the 11-plus year bull market rally in stocks (i.e., SPX) closely resembles that of the Wilshire/GDP ratio trend. Both show 13-year uptrend channels, and both are struggling to clear above the top of their respective uptrend channels. Do the breakouts above the top of the uptrend channels confirm accelerated channel breakouts, igniting another stock market melt-up? Or will repeat failures to clear the top of the uptrend channels to warn of a peak and the end to the stock market rally? Will another consolidation alleviate an overbought condition? The return to the previous breakout and the bottom of the uptrend channel at 1.399-1.43 will likely lead to a cyclical bear decline in stocks. The ability to find support here may also signal the end of the cyclical bear and the resumption of the structural uptrend.


S&P 500 Index/US GDP Ratio Analysis


SPX as a ratio of the US GDP is currently trading at 0.192. It has surpassed its 2000 high (0.1485 and the Feb 2020 high (0.1548), confirming a structural breakout. The ratio nears the top of its 13-year uptrend channel between 0.1448-0.1485 and 0.2000-0.2020, suggesting an inflection. A convincing surge above the channel at 0.2000-0.2020 confirms an accelerated channel breakout. Will this trigger another stock market melt-up? Repeated failures to clear the top of the pivotal uptrend channel signal a stock market top and the start of a correction, deep correction, or a cyclical bear. The ability to maintain support at 0.1485-0.1485 led to the resumption of the structural bull.


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

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