Mastering the Buffett Indicator: Your Guide to US Market Valuations

Using Warren Buffett's Favorite Tool to Navigate Market Trends and Investments:

Introduction to Buffett Indicator:

Stock market experts keep a constant eye on specific stocks as well as market-wide valuations that help them figure out the right time to enter or exit their position from various stocks and markets.

One of such indicators is called the Warren Buffett indicator, which essentially is a ratio of any country’s total value of all stocks listed, to its GDP. This ratio fluctuates over time since the value of the stock market can be very volatile, but GDP tends to have a much more predictable nature. 

The indicator shows how the stock market of a country is growing relative to the country’s GDP. If the market is growing at an unusually faster pace than the actual economy, then it may be in a bubble.

Knowing this indicator can provide an investor a basic idea of the valuation of an entire country’s stock market! For Instance, there are over 5,000 companies listed across US exchanges like the NYSE and the Nasdaq. The index takes into account the entire market cap which includes all listed stocks and divides it with the GDP.

What is the Buffett Indicator? (Market Cap to GDP ratio)

The Buffett Indicator takes the total market capitalization which includes all the listed companies of a country and divides it with the total GDP - be it annual or quarterly. 

The Indicator, also known as the market cap-to-GDP ratio, compares a country's overall stock market value to its total annual economic output. 

Imagine a price to sales ratio - which tells an investor how much a particular company’s share price is performing relative to its sales numbers. Similarly, the indicator aims to determine whether the stock market is overvalued or undervalued as a whole.

Basics of Warren Buffett Indicator 

The Buffett Indicator's fundamental principle is that the market capitalization of all publicly listed firms in a particular nation should be in line with its GDP. In a nutshell, the value of the stock market should reflect a country's whole GDP.

According to Warren Buffett, this indicator is "probably the best single measure of where valuations stand at any given moment." He believes the stock market may be overpriced and might be due for a correction when the indicator is markedly higher than its historical norm. On the other hand, if the indicator is far below its historical average, it can be a sign that the market is undervalued and offers good prospects for investment.

Warren Buffett Indicator - How does it work?

Let’s take a look at how the following table which shows how the indicator functions:

Source: US Fed, currentmarketvaluation.com, CEIC

According to the indicator, a BI reading above 100% generally depicts that the market is overvalued relative to its GDP. Now, historically the US has its BIs well above 100%. In this case, it's imperative to know the average BI. Let’s assume an average BI of 180 in the above table. That would mean that the US stock market is undervalued as on June 26, 2023.

Generally, a stock index is much more volatile since there are multiple factors that affect the share prices of individual stocks which in turn affects the market wide capitalization.

Alternatively, a country’s GDP changes are slow and gradual, instead of being volatile like stocks. Once an investor calculates the Buffett Indicator (Total market cap divided by the GDP), the next is to find the average Buffett Indicator. 

Once the average is found - which acts as your base line - an investor can purely plot the various indicators on a line graph like shown below. Anything above the base line or the average Buffett Indicator can be considered as overvalued and vice versa. 

What does the current levels of the Buffett Indicator say about the US market?

Based on the above graph, US stock indexes have been considerably overvalued according to the Buffett indicator. Generally a BI reading above 100% is read as the market being overvalued. 

The latest Buffett indicator for US equities show readings of 176%, which is also quite higher than the 10-year average of 161%, indicating US stock market is quite overvalued. 

Investors having exposure towards US equities can utilize this indicator to figure out when to increase allocation towards a certain market and when to pull back on investments. An undervalued market generally means that there are quality companies ready to be picked up at a cheaper cost, while an overvalued market means you're paying more for a stock than what its really worth. 

What does the current levels of the Buffett Indicator say about Indian markets?

Indian markets seem to be relatively cheaper compared to its US counterparts considering the Buffett indicator for India is below 100. 

However, we cannot directly compare Indian and US markets. For instance, India's total market capitalization is around $3 trillion, whereas the market cap for US stocks like Google, Apple and Nvidia together is more than India's total market capitalization!

How to interpret Buffett Indicator?

Buffett Indicator: Who should use this indicator?

Passive investors who like investing in large index funds instead of picking out individual stocks can use this indicator to get a fair idea on valuations of said indexes. Simple math says it is beneficial to invest when the company or a market is relatively undervalued against when it is running hot with over the top investments and valuations.

Consider it like buying a car - There is a fair market value for a car, then there are discounted prices. In case of huge demand, the prices might be higher than the fair value.

An investor would benefit from buying it cheaper, earlier rather than buying it when it's more expensive.

This sort of strategy could be successful over the course of many years, but it likely wouldn’t be beneficial to investors or traders with shorter time horizons.

This is not investment advice. Investments in the securities market are subject to market risk, read all the related documents carefully before investing. Past performance is not indicative of future returns.