Does Buffett’s indicator say markets are going to crash?

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“The ‘Buffet indicator’ says the stock market will crash. Such was an email I received recently and was worthy of a more detailed discussion. Let me start with my favorite line from “The princess Bride.”

“I do not think it means what you think it means.”

The Buffett Indicator is a valuation measure that compares stock market capitalization to Gross Domestic Product. A favorite of Warren Buffett, the indicator it is below 2.44 times the market capitalization of GDP. That number doesn’t mean much on its own, but it’s amazing when placed in a historical context.. Even after the recent slump in markets, the ratio remains one of the highest on record, north of the 2.11 level recorded during the dot-com bubble. 2000and considerably high compared to the average since 1950.

Ratio of market capitalization to GDP adjusted for inflation

Since 2009, repeated monetary interventions and zero interest rate policies have led many investors to rule out any measures of “valuation.” The reasoning is that since there was no immediate correlation, the indicator is wrong.

The problem is that valuation models are not, and were never intended to be, market timing indicators. The vast majority of analysts assume that if a valuation measure (P/E, P/S, P/B, etc.) reaches some specific level, it means that:

  1. The market is about to crash and;
  2. Investors must be 100% cash.

Such is wrong. Valuation measures are just that: a measure of current valuation. More importantly, when valuations are excessive, it is a better measure of “investor psychology” and the manifestation of “Elder Fool Theory”.

What valuations do provide is a reasonable estimate of long-term investment returns. It stands to reason that if you overpay for a stream of future cash flows today, your future return will be low.

Why the Buffett indicator is valuable

Although often overlooked, the Buffett indicator tells us a lot as it measures “Market capitalization” a “GDP”. To understand the relative importance of the measure, we must understand the business cycle.

Buffett Indicator

The premise is that in an economy driven roughly 70% by consumption, people must produce in order to have a paycheck to consume. That consumption is where corporations get their income and, ultimately, their profits. If something happens that leads to less production, the whole cycle is reversed and leads to an economic contraction.

The example is simplistic, as many factors affect the economy and markets in the short term. However, economic growth and corporate earnings have a long-term historical correlation. So while it is possible for profits to grow faster than the economy at times, that is, after the recession, they cannot outperform the economy indefinitely.

year-on-year growth

Since 1947, earnings per share have grown 7.72% annually, while the economy has expanded 6.35% annually. Once again, the close relationship between growth rates should be logical. Such is particularly the case given the significant role spending plays in the GDP equation.

Thus, the Buffett Indicator tells us that overvaluation is not sustainable when the market capitalization of stocks grows faster than economic growth can support. Therefore, a market capitalization index (the price investors are willing to pay multiplied by the total number of shares outstanding) more than 1.0 is overvalued and below 1.0 is undervalued. Today, investors are paying almost 2.5 times what the economy can generate in income and profits.

Does that overvaluation mean the stock market is going to crash? Nope.

However, there are significant implications that investors should consider.

Valuations and returns in time

As is always the case, while the ratings are terrible “market timing” indicator, they are an excellent predictor of future returns. Earlier I quoted Cliff Asness on this particular topic:

“Ten-year forward average yields fall almost monotonically as the Shiller P/E rise begins. Also, as Shiller’s starting P/E increases, the worst cases get worse and the best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a nominal 10% return (or with current inflation around 7-8% real) on the stock market, you’re basically supporting the absolute best case ever to play again, and supporting something drastically above the average case of these ratings.”

We can demonstrate this by looking at 10-year forward total returns against various levels of P/E ratios historically.

10-year forward real yields

Asness continues:

“It’s [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still a lot of variability around its predictions even over decades. But, if you don’t lower your expectations when Shiller’s P/E is high for no good reason — and in my opinion, the critics have not given a good reason this time — I think you’re making a mistake.”

And since we’re talking about Mr. Buffett, let me remind you of one of Warren’s most insightful quotes:

“Price is what you pay, value is what you get.”

the “Buffet Indicator” confirms Mr. Asness’s point. The chart below uses Wilshire 5000 market capitalization vs. GDP and is calculated on quarterly data.

Buffett indicator vs 10-year returns

Not surprisingly, like any other valuation measure, forward-looking return expectations are substantially lower over the next ten years than they have been in the past.

Basics don’t matter until they do

In the “heat of the moment,” the basics don’t matter. As said, they are poor indicators of time.

In a market where momentum is driving participants due to the “Fear of missing out (FOMO)”, fundamentals are displaced by emotional biases. Such is the nature of market cycles and one of the main ingredients needed to create the right environment for an eventual reversal.

See, I said eventually.

As David Einhorn once said:

“Bulls explain that traditional valuation metrics no longer apply to certain actions. The longs trust that everyone else who owns these stocks understands the dynamics and won’t sell either. With holders reluctant to sell, shares it can only go up, seemingly to infinity and beyond. We have seen this before.

There There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top and it’s hard to predict when that will happen.”

Furthermore, as James Montier previously stated:

Current arguments as to why this time is different are wrapped up in secular stagnation economics and standard finance workhorses like the equity premium model. While this may lend a veneer of respectability to those dangerous words, taking the arguments at face value without considering the evidence seems to me to at least be a common link with the previous bubbles.

Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, return expectations for the next ten years are as likely to be negative as they were for the ten years after the late 1990s.

Investors would do well to remember the words of then SEC Chairman Arthur Levitt. In a 1998 speech entitled “The Numbers Game” he stated:

“While the temptations are great and the pressures strong, illusions in numbers are just that: short-lived and ultimately self-defeating.”

Still, there is a simple truth.

“The stock market is NOT the economy. But the economy is a reflection of what supports higher asset prices: earnings.”

No, the Buffett Indicator does not mean that the markets will definitely crash. However, there is a more than reasonable expectation of disappointment in future market returns.

original post

Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.

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