Warren Buffett is one of the most famous investors who has ever lived. Nicknamed “the Oracle of Omaha,” he has amassed a fortune that few could ever dream of owning. As new investors look for opportunities to build wealth in the stock market, they often look to Buffett’s way of investing, hoping to follow in his footsteps.
There’s quite a bit to be learned from following Buffett and his holding company Berkshire Hathaway. One of the biggest lessons may be that by evaluating current valuations compared to fair-market values, you have the ability to greatly increase your profitability on Wall Street.
Buffett doesn’t just offer up ways to look at valuation from a single-stock perspective. In fact, he’s the inventor of the Buffett indicator, a metric used by both investors and economists to determine the state of the overall market.
What Is the Buffett Indicator?
The Buffett indicator is an investing metric that tells you whether stocks are generally overvalued, trading at a fair market value, or undervalued. This is important information because the indicator can help predict the state of the market and whether bear or bull markets are on the horizon.
Buffett first described the indicator as a measurement of the ratio of the total stock market capitalization to gross domestic product (GDP).
This compares the total value of the entire stock market, or the overall stock market capitalization, to the total production of the U.S. economy, which Buffett called “the best single measure of where valuations stand at any given moment.”
Buffett and other market experts and economists believe that by comparing the total value of the stock market to the production of the U.S. economy, you will clearly see whether the stock market is overvalued or undervalued, or if the current market capitalization is fair.
For example, if the total value of all assets on the market adds up to $30 trillion, and the value of all goods and services produced in the United States is $20 trillion, the Buffett Indicator would produce a value of 150%, meaning that the value of the stock market is one and a half times that of the U.S. GDP.
That would mean the stock market has a valuation that’s much higher than the total production of the economy,
When the indicator is below 50%, it is considered low, suggesting that equities are trading at generally undervalued levels. When the indicator is between 51% and 99%, the market is considered to be fairly valued. Any time the indicator crosses the 100% line, it suggests that the market is overvalued. Finally, anything over 200% is significantly dangerous.
Buffett summarized how to interpret the indicator this way: “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.”
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How the Data Is Calculated
As mentioned above, the indicator’s value is calculated by comparing the GDP to the overall market capitalization in the U.S.
First, the total value of the U.S. stock market is calculated using data from the Wilshire 5000 Total Market Index, an index considered the broadest among American publicly traded companies, as well as from data compiled from the U.S. Federal Reserve, or simply the Fed.
This total is then compared to the GDP, the data for which is generally compiled from the U.S. Bureau of Economic Analysts, as well as data from the Fed.
The good news is that the world’s biggest search engine has already done all of that legwork for you. Simply search Google for “U.S. total stock market cap” and “U.S. GDP” to find the figures, then divide the GDP by the market cap to get the final result.
The Historic Success of the Buffett Indicator
The indicator has a long track record of successfully predicting some of the most significant market movements in recent history. For example:
- The Dot-Com Bubble. The dot-com bubble happened when investors piled into any stock related to the Internet as the new technology grew in popularity leading up to the year 2000. Toward the end of the bubble, the indicator was sitting at 146%, pointing to the fact that significant overvaluations were taking place on Wall Street. When the bubble popped, it caused dramatic declines that led to significant losses for many investors.
- The Great Recession. Prior to the Great Recession of 2007, the indicator made yet another wildly successful prediction. Sitting at 137%, the indicator again suggested that the market would see significant declines due to a tremendous overvaluation of stocks. That proved to be the case, as one of the most significant economic events in history soon unfolded.
- The Recovery. In 2009, toward the end of the Great Recession, the indicator pointed to a looming recovery, sitting at just 51%. Lo and behold, that recovery would soon take place, sending values in the market soaring in what proved to be the longest bull run in Wall Street’s history, according to Cazenove Capital.
What the Indicator Says About the Stock Market in 2021 and 2022
While the COVID-19 pandemic led to some pain in the stock market, the declines proved to be short-term, and the longest bull market in history continues. As stocks reach all-time highs, some suggest that a storm is on the horizon that could bring a financial crisis the likes of nothing we’ve seen before.
So, what does the Buffett indicator suggest? Is the bull market leading to overvaluations across the market as a whole?
According to historical averages, the answer is yes. In early 2021, the indicator sat at 234%.
Keep in mind that Buffett himself has said that when the indicator nears 200%, you’re playing with fire. The indicator currently registering well above that threshold suggests that stocks right now are extremely expensive. This could mean stocks are in for significant declines the next time the market corrects.
Some Say a Low-Interest Rate Environment Validates Excessively High Valuations
While the indicator suggests that doom and gloom are ahead for investors, you shouldn’t use a single indicator to determine what to do with your investment portfolio. Even with a concerning level being seen on the indicator, there are other factors at play here.
One of the biggest factors leading to the significant overvaluations is the fed funds rate — the interest rate set by the Federal Reserve representing the amount of money banks pay for overnight lending from one to another.
The lower the fed funds rate, the lower the cost of borrowing across the board.
Since the 2007 financial crisis, and especially since the COVID-19 pandemic, the Fed has kept the fed funds rate at historic lows in an attempt to keep the economy stimulated. As a result, there’s quite a bit more money flooding through the U.S. economy than there is on an average basis.
With the Federal Reserve not likely to increase the rate in the foreseeable future, these excess funds will equate to more spending, which is good for the market as a whole and drives equity prices up.
This is important because when returns are low on safe-haven investments, the investing community tends to avoid them, opting to use their investing dollars to purchase equities in search of higher returns.
Some argue that the historically low fed funds rate is largely to blame for the historically high level of the Buffett indicator and that this high level is sustainable as long as the Federal Reserve’s rate isn’t increased.
Although this is a strong argument, the cautions of the Buffett indicator should not be ignored. After all, historically, it has successfully predicted every major fallout in the equities market for the past three decades.
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What Should You Do When the Indicator Is High?
When the indicator is higher than 100%, it’s generally cause for caution. The stock market is a relatively balanced system, where overvaluations tend to lead to declines, bringing prices back to fair market values.
When the Buffett indicator is trending on highs, it’s important to prepare for an incoming bear market in which stock prices could drop like a brick falling from the Empire State Building.
There are a few actions you can take leading up to bear markets to protect yourself:
- Get Rid of Any Excessive Risk. Penny stocks and stocks in emerging markets tend to come with increased risk compared to other, more stable investments. When the indicator is high, it’s a good idea to divest these investments and look for safer alternatives.
- Cash in on Overvalued Stocks. Review the valuation metrics for every stock in your portfolio. If you find that any asset you’ve got money tied up in is overvalued compared to its peers, cash in on that investment and look for undervalued opportunities.
- Look for Income Opportunities. Fixed-income investments aren’t the only investments that generate income. Even in low-rate environments when bonds aren’t attractive, investors have the option to invest in blue-chip stocks that are known for paying significant dividends to investors. These stocks represent large companies that display more recession resistance than others on the market, helping to keep your money safe should a downturn take place and providing dividend checks in the process.
- Invest in Utilities. Large utilities companies are generally safe investments. After all, how likely are you to go without access to electricity, clean water, and sewage services? Even when economic conditions are poor, these companies are resilient, making them a great store of value to get through bear markets. Moreover, utilities companies are known for paying compelling dividends, adding income to the opportunity.
- Invest in Consumer Staples. Finally, consumer staples are another category of stocks that tend to hold value even during economic recessions and bear markets. These stocks represent companies that produce staple products like food, toothpaste, and toiletries, all of which consumers can’t live without even in times of economic hardship.
What Should You Do When the Indicator Is Low?
When the indicator is low, it suggests stocks on the market are trading at low valuations in general. That suggests a market comeback is likely ahead, setting the stage for tremendous growth to capitalize on. Here’s what you should do when the indicator is low:
- Reduce Exposure to Safe Havens. Safe-haven investments won’t experience the same level of growth that other investments will when a market recovery takes place. Although you don’t want to completely divest your safe-haven holdings, it is a good idea to reduce exposure to these investments and look for opportunities that are likely to generate the most growth during a recovery.
- Look for Emerging Opportunities. Stocks in emerging markets, or relatively small companies that are building a compelling business, have some of the highest potential for significant growth when market conditions grow more favorable. When the indicator is low, suggesting that a big recovery is on the horizon, these are perfect stocks to take advantage of.
- Look for Value Stocks. When the indicator is low, valuations will be relatively low across the board. However, some opportunities will be larger than others. Do some research to find stocks that are trading at lower prices than other, similarly sized companies within their industries. The larger the undervaluation, the larger the opportunity.
- Look for Growth Stocks. The growth investing strategy is centered around investing in stocks that are experiencing a growth trend in revenue, earnings, and price. Growth stocks are likely to speed up the pace of their growth as a down market reverses direction and starts working its way up.
What Should You Do When the Indicator Is In the Middle?
When the indicator is in the middle, the market is trading at a relatively fair value. During these times, the market could go in either direction, depending on news and events in the future. So, you’ll want to follow a bit of a mixed model.
- Follow a Strict Asset-Allocation Strategy. The best way to go about asset allocation is to use your age as a guide. For example, if you’re 20 years old you might keep 20% of your investments in safe-haven assets with the remaining 80% invested in equities that offer better growth potential. As you age, your allocation should shift, investing slightly more in safe havens and slightly less in equities with each passing year. When the market values are fair, it’s best to strictly stick to this asset allocation strategy.
- Growth, Value, and Income. The equities portion of your portfolio should focus on one of the three major investing strategies — growth, value, and income — or a mix of the three. These strategies are based on using various metrics to determine the best course of action in the market based on the search for growth, purchasing stocks at a discount, or generating a meaningful income through your investments.
Warren Buffett is one of the most well-respected financial experts in the world. The student of Benjamin Graham, otherwise known as the father of value investing, Buffett has taken what he learned from Graham and created an empire.
That empire was ultimately built on a foundation of knowledge, a keen ability to discern a company’s fair market value, and an uncanny ability to invest in undervalued opportunities at the right times.
His indicator is a timing tool, designed to tell you when it’s the right time to make different moves in the market. Ultimately, the Buffett indicator should be considered whenever you’re researching new investment opportunities, making it a must-have tool in any investor’s toolbox.