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Market Cap To GDP: The Buffett Valuation Indicator

By Doug ShortMarket OverviewMar 31, 2015 12:43AM ET
www.investing.com/analysis/market-cap-to-gdp:-the-buffett-valuation-indicator-246776
Market Cap To GDP: The Buffett Valuation Indicator
By Doug Short   |  Mar 31, 2015 12:43AM ET
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Note from dshort: This update includes the Q4 Third Estimate of GDP and the alternate version with the First Estimate of the Q4 GNP divisor.

Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment."

The four valuation indicators I track in my monthly valuation overview offer a long-term perspective of well over a century. The raw data for the "Buffett indicator" only goes back as far as the middle of the 20th century. Quarterly GDP dates from 1947, and the Fed's B.102 Balance sheet has quarterly updates beginning in Q4 1951. With an acknowledgement of this abbreviated timeframe, let's take a look at the plain vanilla quarterly ratio with no effort to interpolate monthly data.

The strange numerator in the chart title, MVEONWMVBSNNCB, is the FRED designation for Line 39 in the B.102 balance sheet (Market Value of Equities Outstanding), available on the Federal Reserve website. Here is a link to a FRED version of the chart. Incidentally, the numerator is the same series used for a simple calculation of the Q Ratio valuation indicator.

The Latest Data

I've now updated the GDP denominator with the BEA's Q4 Third Estimate. The numerator is from the Fed's Z.1 Financial Accounts. The indicator remains over 2 standard deviations above its mean at an interim high of 127.4%. The bigger news will be our first look at the Q1 2015 GDP data on April 29th.

The Buffet Indicator: Corporate Equities to GDP
The Buffet Indicator: Corporate Equities to GDP

Here is a more transparent alternate snapshot over a shorter timeframe using the Wilshire 5000 Full Cap Price Index divided by GDP. I've used the FRED data for the stock index numerator (WILL5000PRFC).

A Buffett Indicator Varian: Wilshire 5000 to GDP
A Buffett Indicator Varian: Wilshire 5000 to GDP

A quick technical note: To match the quarterly intervals of GDP, for the Wilshire data I've used the quarterly average of daily closes rather than quarterly closes (slightly smoothing the volatility).

How Well do the Two Views Match?

The first of the two charts above appears to show a significantly greater overvaluation. Here are the two versions side-by-side. The one on the left shows the latest valuation over two standard deviations (SD) above the mean. The other one is noticeably lower. Why does one look so much more expensive than the other?

The Buffett Indicator: Corporate Equities To GDP
The Buffett Indicator: Corporate Equities To GDP

Buffett Indicator Variant: Wilshire 500 To GDP
Buffett Indicator Variant: Wilshire 500 To GDP

One uses Fed data back to the middle of the last century for the numerator, the other uses the Wilshire 5000, the data for which only goes back to 1971. The Wilshire is the more familiar numerator, but the Fed data gives us a longer timeframe. And those early decades, when the ratio was substantially lower, have definitely impacted the mean and SDs.

To illustrate my point, here is an overlay of the two versions over the same timeframe. The one with the Fed numerator has a tad more upside volatility, but they're singing pretty much in harmony.

The Buffett Indicator: Comparing 2 Versions
The Buffett Indicator: Comparing 2 Versions

Incidentally, the Fed's estimate for Nonfinancial Corporate Business; Corporate Equities; Liability is the broader of the two numerators. The Wilshire 5000 currently consists of fewer than 4000 companies.

What Do These Charts Tell Us?

In a CNBC interview earlier this spring CNBC interview (April 23rd), Warren Buffett expressed his view that stocks aren't "too frothy". However, both the "Buffett Index" and the Wilshire 5000 variant suggest that today's market is indeed at lofty valuations, now well above the housing-bubble peak in 2007. In fact, we can see in the first chart above only four quarters (during the dot.com bubble) with higher valuations. The latest estimate is about half-way between two and three standard deviations above the mean valuation.

Wouldn't GNP Give a More Accurate Picture?

Note: GNP estimates lag GDP, so this section is based on the First Estimate for Q4 GNP.

That is a question I've been asked multiple times. Here is the same calculation with Gross National Product as the denominator; the two versions differ very little from their Gross Domestic Product counterparts.

The Buffett Indicator: Corporate Equities to GNP
The Buffett Indicator: Corporate Equities to GNP

A Buffett Indicator: Wilshire 500 To GNP
A Buffett Indicator: Wilshire 500 To GNP

Here is an overlay of the two GNP versions -- again, very similar.

Buffett Indicator: Comparing 2 GNP Versions
Buffett Indicator: Comparing 2 GNP Versions

Another question I've been repeatedly asked is why I don't include the "Buffett Indicator" in the overlay of the four valuation indicators I update monthly. I've not included it for various reasons: The timeframe is so much shorter, the overlapping timeframe tells the same story, and the four-version overlay is about as visually "busy" as I'm comfortable graphing.

One final comment: While I see this indicator as a general gauge of market valuation, it it's not useful for short-term market timing, as this overlay with the S&P 500 makes clear.

Buffett Indicator: Corporate Equities to GDP
Buffett Indicator: Corporate Equities to GDP

Market Cap To GDP: The Buffett Valuation Indicator
 

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Market Cap To GDP: The Buffett Valuation Indicator

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