Are Markets Overvalued Now? Yes…According to the Buffett Indicator

dow jones nasdaq s&p sti stocks Jan 15, 2018

by: Tam Ging Wien


All examples and stocks quoted here in this article and on the ProButterflyTM site are for learning purposes; it does NOT constitute financial advice or a Buy/Sell recommendation. Contents are reflective of personal views and readers are responsible for their own investments and are advised to perform their own independent due diligence and take into account their own financial situation. If in any doubt about the investment action you should take, you should consult a professional certified financial advisor.


 

The Dow Jones, S&P, Nasdaq and even our very own STI has been breaking all-time highs week after week. Some think that the rally is set to continue well into 2018. But some are calling it tops and a major market crash could be in the making.

But on what basis can we value the overall market?

The Buffett Indicator

Back in 2001, during an interview with Fortune Magazine, the sage of Omaha – Mr Warren Buffett shared an indicator that he personally used to gauge the valuation of the stock markets using a Total Market Capitalisation to GDP Ratio. During the interview, he called it "probably the best single measure of where valuations stand at any given moment".

This ratio made popular thanks to the interview became known as The Buffet Indicator. It is simply the ratio of the total market capitalisation of all companies in the US to the US GRP based on quarterly figures.

The total market capitalisation data can be obtained from the Economic Research of the Federal Reserve Bank of St. Louis – Nonfinancial corporate business; corporate equities; liability, Level (code: NCBEILQ027S). The source link is https://fred.stlouisfed.org/series/NCBEILQ027S.

The GDP figures are also obtained from Economic Research of the Federal Reserve Bank of St. Louis – Gross Domestic Product (code: GDP). The source link is https://fred.stlouisfed.org/series/GDP.

Source: Economic Research of the Federal Reserve Bank of St. Louis (FRED)

Using the raw data obtained, we plotted a chart of The Buffet Indicator since 1980 till now.

What we found was that The Buffett Indicator is currently at its second highest point since the 1980s at 131.46%. The only time it has been higher was during the Dot Com Bubble in 2000 at 151.27%.

During the Global Financial Crisis of 2008, this indicator dipped as low as 59.54%.

The longer term average since 1980 is at 79.66%.

Using these figures as a guide, we can get a sense of the valuations that the US market are now in bubble territory based on historical data and is about 31.46% overvalued.

The Inverse-Buffett Indicator

Source: Economic Research of the Federal Reserve Bank of St. Louis (FRED)

Hum, saying that the market is now 31.46% overvalued isn’t very impactful. It’s hard to comprehend how overvalued 31.46% is.

Another way that an investor can think about it is for each dollar of a company share value that is being invested, how much economic activity is generated. Thinking about it this way would be the inverse – GDP-to-Total Market Capitalisation Ratio. Let’s call this the Inverse-Buffet Indicator. Thinking about it in this way is more impactful as an investor can see from an investment returns perspective.

In today’s terms, for each dollar invested in the US stock market, the economic output is only 76c. At the peak of the Dot Com Bubble, that figure was 66c. The long term historical average since 1980 is $1.47.

Thinking about it this way is certainly more impactful and drives home the point of how overvalued the market currently is. It would be completely illogical to invest a dollar only to get back 76c of value! So this certainly indicates that we are in an environment where the market valuations are insane and driven completely by irrational reasons.

Is a Stock Market Crash Coming?

Is the market now trading at overvalued prices? The answer is a resounding YES!

But is a stock market crash coming soon in the next 6 months? This question is a lot harder to answer. There is unfortunately no crystal ball that we are aware of that allows us to predict the exact time and date of a stock market crash.

Irrational exuberance can last for much longer than most people imagine or anticipate.

This time coupled with ultra-low interest rates and loose monetary policy could be the reason why markets are still continuing to rally. We are in a situation where interest rates around the world are at unprecedented lows and massive money printing has never been used before.

While we don’t know for how much longer this rally will last, we don’t want to miss out of the rally. Market bears have been calling for a correction since 2015, 2016 and throughout 2017 but we have still not seen any sign of a correction. If an investor had exited all their positions back then, they would have missed out on the tremendous rally in 2017.

On the other hand, we also recognise that the valuations at this point of time are near historical highs. Therefore, we also want to remain cautious and take some profit from stocks in cyclic sectors and increase our cash reserves. We will want to remain vested in stocks with high cash flow and free cash flow, low debts with a strong balance sheet of high quality assets.

We think that keeping a cash reserve of perhaps 50% while continuing to stay 50% invested draws a good balance at this moment. With a high cash reserve, we are able to take advantage to pick up high quality stocks for cheap when the markets correct, while the staying invested with the remaining 50% would let us ride the upside in the current bull markets.

This ratio is arbitrary and each investor can tune it according to his or her own risk provide, investment objective and risk appetite. A 60-40 or 40-60 ratio would still be a reasonable balance.

We are presently still invested, but as the markets continue to climb, we are likely to take more and more profits from our gains and stashing it away for that opportunity of a decade!

In the end, believe that the markets cannot continue to remain in an overvalued position forever. It would need to revert back to its long term historical mean.

What Is Driving This Overvaluations In Stock Prices?

There are many theories regarding what are driving up asset prices. Perhaps it’s the loose monetary policy and historically low interest rates.

But another theory could be due to rising trend of passive investing through ETFs.

ETFs were introduced as a response to research that appear to show that many professionally managed active funds do not generate market index beating returns in the long term.

Therefore, instead of actively trying to manage and outperform the markets, why not just track the market indexes instead? As a result many ETFs are designed to track and replicate the performance of a particular underlying index or assess class. ETFs tracking a particular index would therefore in theory reflect the same percentage gain or loss of the index.

Investors however has continued to pile money into these passive investment vehicles as they have been giving good returns over the last decade just simply tracking an index! Lured with an easy way to invest without the need for any effort, investors continued to pile money into these passive investment vehicles.

To meet the demand, more and more ETFs where introduced. However, in order to replicate an index, the ETF would need to purchase the underlying assets. These passive vehicles will buy the exact same stocks without thought or consideration to valuation. This mindless index replication pushes funds to chase rising stock prices that make up the underlying indices.

The global ETF asset under management is estimated to be around $3 trillion at the end of 2016. With all these trillions of dollars bidding up the same stocks, it is no surprise that we are now seeing the crazy valuations on the markets.

When a global market correction occurs again similar to the 2008 Global Financial Crisis, we can predict with fair certainty that the stocks that will be hit the hardest are those that are being bought up for index tracking.

Perhaps it is time for you to play a more active role in your investing today.

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