The Buffett Indicator
The Buffett Indicator
Investing using the Buffett Indicator
The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do. — Warren Buffett
In his famous speech at the Allen Sun Valley Conference in 1999, Warren Buffett highlighted a peculiar statistic:
The Dow Jones Industrial Average (DJIA) traded at 874 in 1961 and ended at 875 in 1981. For 17 years, the stock market went nowhere. But, during the same time, both the U.S. GDP and the sales of the Fortune 500 had increased five-fold.
Looking at the next 17 years, from 1982 to 1999, we saw a very different picture. The GDP growth was less than half of the previous period, but the DJIA rose more than ten-fold, from a middling 875 to a stunning 9,181.
The simplest explanation for this mismatch was the change in the Federal Interest Rates. Government bonds went from 4% in 1964 to a dizzying 15% by 1981, dragging down equity prices. In the next 17 years, Paul Volcker successfully brought down inflation and, thereby, the Fed Rate to a reasonable range of 3-5%.
But, buoyed by the stock returns of the last two decades (1980 to 2000), investors were not thinking rationally. In a survey run in 1999, investors who had invested for less than five years expected an annual return of 22.6% over the next ten years. Buffett, on the other hand, with his wealth of experience, expected the stocks to mean-revert, and he predicted that the annual returns for the next 17-year period from 1999 to 2016 would be only ~6%.
I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like they've performed in the past 17.
If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. — Buffett in ‘99
Exactly 17 years later, when Forbes backtested the returns from 1999 to 2016, the annualized total return to investors from the Dow Industrials was 5.9%.
The mismatch between the growth rate of a country and its stock market led Buffett to create the market value of equity (MVE) to the gross domestic product (GDP) ratio. Buffett claimed this to be “probably the best single measure of where valuations stand at any given moment”.
MVE/GDP is exceptionally intuitive — The stock prices ultimately reflect a claim of future profits the companies can generate, and GDP measures the total value of goods and services produced in a country. If the former goes up without a proportional rise in the latter, we can reliably assume that fundamentals are not driving the stock price.
A Short History of Buffett Indicator
A simple way to calculate the ratio is to take the total U.S. stock market value and then divide it by the annualized GDP.
Calculating this ratio back a few decades, we can immediately see some interesting trends. During the dot-com bubble in ‘99 and the zero-interest hype of ‘21, the Buffett Indicator was two standard deviations above the historical trend line, highlighting that the market was significantly overvalued (before the crash). At the same time, the indicator is not foolproof, as it was barely above the historical average just before the Global Financial Crisis.
As of today (25th Feb 2024), the Total Stock Market index is at $50.1 Trillion, and the annualized GDP is ~ $28 Trillion. This brings the Buffett Indicator to 178%, suggesting the U.S. stock market is overvalued.
Investing using the Buffett Indicator
Even though Buffett created the indicator two decades ago, there were no significant studies analyzing its forecasting abilities yet. At first glance, the Buffett Indicator does seem to have forecasting abilities, and the best time to invest would be when the indicator is at its lowest.
To test the Buffett Indicator more rigorously, researchers collected data from 14 developed countries going back 50 years. The results from their study give us insights into
Performance of the Buffett Indicator in U.S. and international markets
A simple investing strategy using the Buffett Indicator that gave statistically & economically significant alpha.
Limitations of the Buffett Indicator
Let’s dig in: