2-21-14 Market Cap - 1
Source: The Chart Store



Today I am going to make a somewhat nuanced argument about the dangers of indicators and metrics for valuing stocks.

Let’s use arguably the greatest investor of all time, Warren Buffett, and what he describes as, “probably the best single measure of where valuations stand at any given moment.” Buffett’s favorite metric compares the total price of all publicly traded companies to gross domestic product. This metric can also be thought of as a way to judge the valuations for all U.S. companies relative to the total amount of U.S. economic activity. According to Buffett, when the resulting figure is above 100 percent, stocks are overvalued.

A Google search for “Warren Buffett’s favorite indicator” will return several million hits and you can find dozens of articles citing the indicator — it is most often used to prove that stocks are pricey.

The reality of its meaning is much more complex . . . continues here

Category: Really, really bad calls, Technical Analysis, Valuation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

18 Responses to “Buffett’s Favorite Indicator Is Worthless as a Buy/Sell Signal”

  1. mathman says:


    In a Few Short Years, Mainstream Economists Have Gone From Assuming Runaway Inequality Is Harmless to Understanding that It Cripples the Economy

    But Bad Government Policies Are Making Inequality Worse By the Day

    Indeed, a who’s-who of prominent economists in government and academia have now said that runaway inequality harms economic growth, including:
    ◾Current Fed chair Janet Yellen
    ◾Former Fed chairman Ben Bernanke (video continues here)
    ◾Federal Reserve Governor Sarah Bloom Raskin (more)
    ◾Former FDIC Chair Sheila Bair
    ◾Nobel prize winning economist Joseph Stiglitz
    ◾One of America’s leading economists, Robert Shiller
    ◾Former chief IMF economist Raghuram Rajan
    ◾Former U.S. Secretary of Labor and UC Berkeley professor Robert Reich
    ◾Stanford University professor John Taylor
    ◾Northeastern University professor Robert Gordon (more)
    ◾University of Oregon professor Mark Thoma
    ◾University of California professor Emmanuel Saez
    ◾Paris School of Economics professor Thomas Piketty
    ◾Famed economist John Kenneth Galbraith
    ◾Harvard Business School professor David Moss
    ◾Paris School of Economics professor Romain Rancière
    ◾London School of Economics professor Robert Wade
    ◾University of Notre Dame professor David Ruccio
    ◾Harvard professor Lawrence Katz
    ◾Arkansas State University professor Christopher Brown
    ◾Global economy and development division director at Brookings and former economy minister for Turkey, Kemal Dervi
    ◾Societe Generale investment strategist and former economist for the Bank of England, Albert Edwards
    ◾Michael Niemira, chief economist at the International Council of Shopping Centers
    ◾Scott Brown, chief economist at Raymond James
    ◾Former executive director of the Joint Economic Committee of Congress, senior policy analyst in the White House Office of Policy Development, and deputy assistant secretary for economic policy at the Treasury Department, Bruce Bartlett
    ◾World Bank economist Branko Milanovic
    ◾Deputy Division Chief of the Modeling Unit in the Research Department of the IMF, Michael Kumhof
    ◾IMF economist Andrew Berg (and see this)
    ◾IMF economist Jonathan Ostry (and see this)
    ◾IMF economist Charalambos Tsangarides
    ◾Federal Reserve chairman from 1934 to 1948, Marriner S. Eccles
    ◾And many others

    Even the father of free market economics – Adam Smith – didn’t believe that inequality should be a taboo subject.

    Numerous investors and entrepreneurs agree that runaway inequality hurts the economy, including:
    ◾More than half of all international investors polled by Bloomberg
    ◾Billionaire and legendary investment adviser Jeremy Grantham
    ◾Billionaire and hedge fund manager Stanley Druckenmiller
    ◾Billionaire Bill Gates
    ◾Billionaire Warren Buffet
    ◾Billionaire Nick Hanauer
    ◾Numerous other billionaires and top investors

    Indeed, extreme inequality helped cause the Great Depression, the current financial crisis … and the fall of the Roman Empire . And inequality in America today is twice as bad as in ancient Rome, worse than it was in Tsarist Russia, Gilded Age America, modern Egypt, Tunisia or Yemen, many banana republics in Latin America, and worse than experienced by slaves in 1774 colonial America. (More stunning facts.)

    Bad government policy – which favors the fatcats at the expense of the average American – is largely responsible for our runaway inequality.

    And yet the powers-that-be in Washington and Wall Street are accelerating the redistribution of wealth from the lower, middle and more modest members of the upper classes to the super-elite.

  2. [...] Buffett’s favorite market valuation indicator doesn’t work as a buy/sell signal.  (TBP) [...]

  3. Concerned Neighbour says:

    A few points:

    - Globalization does have an impact on the metric, but it’s not uni-directional. Foreign companies are selling stuff in the US, just as US companies are selling stuff abroad. Assuming trade deficits are relatively small, and most trade is done by public companies, can we not largely ignore its impact? I do not have data at my fingertips re: the percentage of trade done by public companies.

    - Markets can stay overvalued for a long time, especially when they’re essentially turned into oligopolies. We’ve had three massive booms in the less than 20 years since we crossed your “green line”, and two massive busts to date.

    - We know that there is massive regulatory capture in favour of corporate interests, and that profit margins are historically high due to massive cost cutting and historically low interest rates (among other things). So it’s not surprising to see this ratio rocketing upwards again.

    • Interesting comments — a few responses:

      1) Imports into US reduce GDP, while exports increase profits (and theoretically support higher capitalizations)

      2) Earnings are being driven by Tech & Finance, two sectors with higher profitability and higher multiples than old line industrials, pharma, utilities, retail, etc. This too theoretically supports higher capitalizations.

      All told, no one metric is a perfect buy/sell signal

      • rd says:

        Re: 1 – More foreign companies have either set up plants in the US or bought US companies, so their profits from work activity in the US may be showing up on foreign exchanges instead of the NYSE (Honda, Toyota, Hyundai plants are examples) like the way S&P 500 foreign profits count on the NYSE – I don’t think the profit globailization swing is anywhere near 30% net change.

  4. mnakash says:

    Very insightful.
    Would you agree than that the price / S&P500 revenues is a better gauge to market valuation? This and other valuation methods which are cyclically adjusted show that the market is overvalued in relation to the past.
    Checking the chart above the ratio showed that the market was overvalued comparing to it’s past during the 60′s till 1972. The 70′s than had low returns. Not sure that it will happen again but it won’t be that surprising considering the valuations, high margins and low interest rates.
    Not to claim that one can predict the returns in the short range or 1-3 years with this (or another) indicator.

  5. Al_Czervik says:

    Perhaps this is what Mathman was getting at, but the indicator could be pointing to the fact that the bounty of our economy is increasingly going to the owners of capital assets and rentiers than to those who supply labor (both mental and physical).

    And with interest rates as low as they have been in recent years, it makes sense that the price of capital assets and economic franchises would be bid up.

  6. rd says:

    I view the big relatively slow moving macro indicators like Market Cap/GDP, CAPE, dividend yield as risk and future return indicators instead of buy/sell indicators. I think Warren Buffet does as well as he has not sold all of his Berkshire Hathaway holdings and converted them to cash yet.

    Right now, I think these indicators are showing that the markets are pricing in very little risk to corporate profits.

    We have some unusual backdrops, such as a 0% Fed Funds rate despite positive GDP growth, not too bad unemployment stats, and an inflation rate greater than the Fed Funds rate. The long-bond interest rates are also at less than their normal premium to the inflation rate. Similarly, profit margins are at very high levels compared to historic norms. Any sort of reversion towards the mean of these parameters is probably not priced into the markets, never mind a bounce to the other side of the mean. Historically, the Fed was not focused on trying to maintain asset prices at a high level – if anything they were concerned about inflation. Since the mid-90s, it has been clear that the Fed has become focused on maintaining high asset values even at the risk of causing bubbles (which they generally deny exist). This is a very unusual situation historically and the risk that this attitude could change significantly does not appear to be priced in. Personally, I expect that the next 1% up move of the long bonds will probably be accompanies by a 0.5% – 1% Fed funds rate increase unlike the taper tantrum increase in the 10-yr rate .

    The indicators tell me that we are more likely to be in a cyclical boom-and-bust market than a long sustained bull market as there is limited head room and lots of downside potential. However, the Fed has also informed us that the only reward for “safety” will be a guaranteed loss of inflation-adjusted “safe” assets.I could see the bull market continuing for years if the economy continues to rise for an extended period of time without a rise in inflation. However, I think that is less probable than some other normal end to the business and monetary cycle.

    So, in my planning I keep a very diversified portfolio. along with lots of broad-based low cost index fundsI have a couple of long-held active funds with a value bias that have done well in up markets and much better than the market in down markets. A significant portion of my equity assets are diversified in foreign markets that have had lower valuation indicators over the past couple of years.I hold some diversified bond funds that should hold their value in a stock bear market and allow for rebalancing at depressed stock values. In the long-run, I would like to be able to have my portfolio at about a 70% equity percentage considering we will have a significant steady income stream from Social Security and a spouse’s pension but at the current valuations, I am keeping the portfolio at 60% equities as I think there is more risk than normal.

    In the asset and future income tracker provided with my 401k, I downgrade the standard returns that they recommend, so that I am not assuming my current asset base will grow at the historic average rates. Instead, I am using lower projected growth rates that I think are more in line with what I would expect over the next 10-20 years based on the current valuation indicators. It would be a pleasant surprise if we got the historic average returns over the next decade and would probably we could retire a couple of years earlier.

  7. The Window Washer says:

    I doubt it matters much but how much would companies listed on multiple exchanges move the needle?

  8. I dunno, I think if you consider the timescale over which this indicator varies, it actually works pretty well. This is a decadal-type indicator, good for secular-bull vs. secular-bear discrimination. If you were a very long term (institutional, family fund, whatever) investor, then yeah, buying and holding stocks in either the 1940s or the late 1970s to early 1980s was a fantastic move. Buying and holding stocks after 1996? Not so smart, since bonds have on the whole done as well or better, and with much less risk or volatility.

    If, on the other hand, your investing timescale is not decades, then yeah, this chart is pretty much useless.

    Someone elsewhere (lost the link, sorry) pointed out some months ago that ANY indicator based on ANY ratio which consists of (something linked to equity prices) divided by (something slow-moving) will show the same kinds of behavior as the plot shown above. The denominator is basically irrelevant if the movement of the ratio is dominated by the equity price swings. So all these charts really suggest is that reversion to the mean is a strong risk for equities. The timescale is not as well defined.

    It’s a bit like going skiing. The best time to ski is on a nice warm sunny day after a nice heavy snowfall has created a winter wonderland. But that’s also when the risk of avalanches is greatest! However, you never know when the avalanche is going to hit, nor do you know exactly where (though some places on the mountain are clearly riskier than others). Similarly, a market that’s zooming up feels great to those owning stocks. But it’s also when the risk of a decline (or at least poor future returns) is largest.

    • Interesting observations — thanks!

    • rd says:

      The investing timeframes for the typical small investor are actually in the decades, so I find these types of indicators very useful. Probably the most important risk that these charts are useful for is to identify periods of time when “sequence of returns” risk could be a major event in the small investor’s income withdrawal period. The very high valuations since 1996 have inflicted major damage on Bengen’s 4% “Safe Withdrawal Rate” types of approaches for people who were retiring after that. Immediately after he published his evaluation based on over a century of data, t became obsolete.

      • Except a) Buffett never sold on this; B) Who could you really afford to miss that much upside over 17 years?

      • rd says:

        I commented earlier that Buffet did not cash out just because his favorite indicator showed major over-valuation. It is not a buy/sell indicator; it is a planning indicator. These valuation indicators tend to go in about two to three decade cycles, so when the valuations are low going into retirement, it is likely that the sequence of returns will be in your favor for the first 10 years or so which is the critical period. When the valuations are high, the sequence of returns are likely to go against you.

        So I use these valuation indicators to help with overall asset allocation and estimating future growth and income. It is not accidental that GMO’s 7 year estimated returns have consistently been on the very low side for well over a decade during the same period that the market cap/GDP has been at very high levels.

        The high valuations of these indicators have been informing me that our family needs to save like crazy in order to fund retirement since we cannot count on the historic average or above historic average returns over the past decade or the coming decade. I am assuming that in my first decade of retirement 5-10 years from now, either my asset base will be reduced by a market crash (but generating higher yields with higher growth potential) or it will be at a fairly high level but with low yields. Either way, you need to save more today than 25 years ago to fund retirement. It means that the money for the 42-inch flat screen TV goes into the 401k instead of on the wall.

        The people who went into retirement in 2000 or 2007 actually believing that their assets were at a permanently high plateau with good income potential found that their ability to generate income was significantly reduced from their expectations even if they appropriately stayed the course on their investment strategies as the periodic large market declines and steady reduction in interest income required that they chew into their asset base more than expected to maintain income.

      • in other words he utterly ignores his favorite indicator . . .

      • rd says:

        He doesn’t ignore it. He uses it as an indicator for timing of new investments. It had plunged to the lowest level in a decade when he stepped up graciously to provide liquidity to Goldman-Sachs. He wouldn’t have provided that liquidity a year earlier or today.

        He does advise people when he thinks the market is over-valuing Berkshire Hatthaway relative to the intrinsic value of its holdings, but its holdings themselves are profitable spinning off cash flow that he can use to buy more assets when he believes they are under-valued. I don’t believe he has been particularly active recently in making new purchases.

        Our current culture is focused on amassing wealth using capital gains and less on acquiring assets that provide steady streams of cash flow. Buffet is still old-school in looking to buy things that will generate future cash flow. He knows that the capital gains will come in time if the business itself is good. However, he knows he can’t control the magnitude of the capital gains, or their timing, as that is up to Mr. Market but he can and does have a lot of influence on their ability to generate cash flow.

  9. innertrader says:

    LONG TERM; when Reagan created the IRAs, it changed the dynamic of the stock market from history. PERIOD. ….. and I don’t lie, like the president.


    BR: In fact, IRA’s were introduced in 1974 in Employee Retirement Income Security Act of 1974 (ERISA). So as it turns out, you DO lie.

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