Two problems with the so-called 'Buffett Indicator' 🤔
The stock market valuation metric has some comparability issues 🤦🏻♂️
A quick Google search for “Buffett Indicator” will return a lot of alarming stories about how a metric Warren Buffett flagged 23 years ago is looking ominous for the stock market today.
In a 2001 interview with Fortune, the legendary investor pointed to what he then called “probably the best single measure of where valuations stand at any given moment”: the market capitalization of the U.S. stock market divided by U.S. gross national product (GNP).
When a valuation metric rises above some long-term average, the market is considered relatively expensive. When it’s below, it’s considered relatively cheap.
Buffett’s observation came near the peak of the dotcom bubble, which was about the time this Buffett Indicator was hitting new highs. A legend was born.
Today, the indicator is above levels seen during the dotcom bubble. In fact, it’s been up there for much of the past four years.
But the metric is not without its issues.
In a note published on Thursday, Morgan Stanley’s Michael Mauboussin identified two of them:
We use gross domestic product (GDP) in our analysis as it is the measure economists commonly reference today and is highly correlated with GNP. … There are a couple of reasons that the ratio of equity market capitalization to GDP may not be comparable over time. The first is that U.S. companies now get more of their sales from outside the U.S. than they did in past decades. GDP does not include those sales. That means the numerator, market capitalization, reflects a larger addressable market than what the denominator, GDP, captures. Second, GDP is arguably understated because it fails to measure accurately the quality of goods and services as well as the value of new goods and services. The rise of digitalization makes measurement today more challenging than in the past.
That first point is something we’ve discussed at TKer quite a bit because it speaks to Stock Market Truth No. 10. More here, here, here, and here.
That said, it may be the case that the stock market is arguably expensive.
But Mauboussin’s observations are a reminder that we should be wary of taking any single metric at face value.
Buffett himself would argue as much.
At Berkshire Hathaway’s annual meeting in 2017, a shareholder asked Buffett his thoughts on the relevance of valuation metrics like the Buffett Indicator and the cyclically adjusted price-earnings ratio.
“Every number has some degree of meaning,” Buffett said. “It means more sometimes than others.”
He added: “And both of the things that you mentioned get bandied around a lot. It’s not that they’re unimportant. … They can be very important. Sometimes they can be almost totally unimportant. It’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.”
There’s no single holy grail metric that’ll tell you everything consistently. And most metrics have issues like the ones Mauboussin identified.
The bottom line is that you should heed Buffett’s advice and be wary of putting too much weight into a single metric. Investing in the stock market just isn’t that simple.
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