Is Buffett's Favorite Market Indicator Flashing a Warning?
U.S. stocks have recorded 54 records this year. However, last Friday, the S&P 500 Index experienced five consecutive days of losses. The 1.69% weekly decline was one of the longest losing streaks since February 2021. Also, the last time SPX witnessed a weekly loss of this magnitude was during mid-June 2021, when it declined 1.9% for the week.
Many Wall Street analysts such as Bank of America, Morgan Stanley, Citigroup, Deutsche Bank, and others have issued warnings of increased U.S. stock market risks in the weeks and months ahead.
A brief review of these research notes cites excessive investment optimism, high valuations, Covid-19 Delta variant, higher than expected inflation, continued supply-chain bottlenecks, and slowing corporate profits and margins.
One high-profile analyst questioned what good news remains since a lot of optimism is priced in the marketplace. Another market pundit issued a note suggesting the current bullish positioning could trigger a market sell-off that results in forced liquidations. Another analyst states that the best days of the market are behind us. Yet another influential analyst issued a dire warning that cash will outperform stocks, government bonds, and credit securities over the next year.
The increase in the cautious outlooks for U.S. stocks is in sharp contrast to the bullish consensus bullish views earlier in the year, suggesting the accommodative monetary and government fiscal policies justified higher stock prices.
There are some signs of weakness in the U.S. stock market, at least from a near-term perspective. For instance, all three major indexes (SPX, INDU, and COMPQ) declined last week and are currently down for the month. If the losses continue, this would be the second monthly loss for SPX since the beginning of the year (i.e., down month during January).
Traders are also uneasy as a triple witching options expirations day occurs this Friday, increasing market volatility during the week. September continues to be a seasonally weak period for U.S. stocks. Investors remain cautious about the timing of the Fed tapering of its asset-buying stimulus program. Others believe the tightening of monetary policy can lead to a volatile period for stocks.
The recent stock market warnings are not new, as many pundits have raised concerns about excessive speculation in U.S. stocks periodically over the past year.
With the above uncertainties creating widespread confusion, we have decided to provide an update on Warren Buffett’s favorite market indicator – the stock market cap to GDP ratio or better known as the Buffett indicator. The Buffett indicator takes the combined market capitalization of U.S. stocks and divides it by the quarterly figure of the U.S. gross domestic product (GDP). Since Buffett’s preferred market gauge has spiked to new all-time highs, some fear stocks are heavily overvalued and poised for a market crash. Below is an update to an earlier report on the Buffet 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 indexes for U.S. equities. The objective is to capture the total market capitalization of the publicly traded companies in the U.S. The original indicator has some drawbacks as the data is published every quarter, and as such, there are lagging tendencies. Nonetheless, since the data dates back to the 1940s, it provides a lot of information, allowing for in-depth and historical trend analysis.
Fundamental Valuation Premises
Many of the fundamental based market indicators that gauge 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 appreciate.
(2) Long-term Growth of Corporate Profitability – corporate profitability tends to return to its long-term historical norm. In the U.S. 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 higher long-term gains in the future.
Current Total Stock Market cap to US GDP
The current Total Stock Market cap to US GDP has surpassed the prior all-time high of 175.9% (Aug 2020). For reference, a ratio of less than 50% denotes a significantly undervalued U.S. stock market. Between 70% and 75% is a moderately undervalued market. Between 75% and 90% is a fair valued market. Between 90% and 115%, it is a moderately overvalued market. A ratio greater than 115% is a significantly overvalued market.
Based on the current reading, this would imply the U.S. stock market is trading at overvalued levels. The lowest reading of 35% occurred 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 U.S. stock market annual returns will be much lower than their historic average and possibly negative in the future?
It remains a challenging question as several structural developments 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. Since the U.S. and global interest rates remain stubbornly low, hovering near-zero, does this imply higher valuations; (2) the fourth technology revolution and the proliferation of technology disruptors, and recently the acceleration of the stay-at-home and work-from-home technology theme. Can this new market paradigm shift translate into higher valuations for an extended time? and (3) the enormous growth and massive inflows into passive and index-based investment vehicles may be important catalysts. Does the strong money flow into passive investments push the stock market and valuations to 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. It can also quantify overbought and oversold market conditions. Attached is the Wilshire 5000 Composite Index (WLSH) divided by the US GDP and the S&P 500 Index (SPX) divided by the US GDP.
Wilshire 5000 Composite Index/US GDP Ratio Analysis
WLSH/US GDP ratio has risen sharply from its 2009 market bottom of 0.555 to a current ratio of 1.93. In the process, it has surpassed the 2000 market peak ratio of 1.399, and the 2018/2019 highs of 1.485/1.447. The breakout in the WLSH to GDP ratio, above its prior all-time highs of 1.399-1.1485 coincided with the strong U.S. stock market rally over the past year. Although an overbought market condition has developed, the pertinent question is whether the ratio can now clear the top of its 11-plus year uptrend channel between 1.40-1.41 and 1.94-1.95. If an accelerated channel breakout occurs, 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 the continued massive inflows of passive and indexed based investments. It is also interesting to point out the 11-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 11-plus year uptrend channel. On the other hand, failure to convincingly surge above the top of its uptrend channel also warns of a stock market peak and the start of a pullback to the bottom of its channel at 1.40-1.41.