What is the Buffett Indicator telling us?

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The Buffett Indicator is telling us that stock markets are richly valued. Investors are paying highly optimistic prices for future corporate profits. Historically this bodes ill for markets because it is unsustainable. However, what is overvalued now could become even more overvalued in the near future. Join the party at your own peril.

What is the ‘Buffett Indicator’?

Over the years, the legendary investor Warren Buffett has educated people all over the world about investing. He showed us how to navigate – and profit – from the treacherous stock market. He regularly expounded his views on financial issues. Occasionally, the sage explains how he valued stock markets.

In 2001, Buffett shared his thoughts in a Fortune article about market valuation. He wrote:

“The market value of all publicly traded securities as a percentage of the country’s business, that is, as a percentage of GNP… is probably the best single measure of where valuations stand at any given moment.”

Since then, numerous astute commentators have coded this up and labelled it as the ‘Buffett Indicator’.

The formula is easy. You need only the market capitalisation of all securities in a country and divide it by the Gross National Product (GNP). The higher the ratio, higher the stock market valuation. In 2001, just after the Dotcom bubble, Buffett himself commented “nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.” 

What is the Buffett Indicator doing now?

The Buffett Indicator is Flashing Amber!

In the US, the ratio is at its highest level since 2007. Advisor Perspectives recently used Wiltshire 5000 against GDP to calculate the Buffett Indicator. The ratio is now at 160%. In other words, the stock market is nearly 60 percent higher than the real economy (see below).

A back-of-the-envelope check: US stock market at the end of 2020 was valued at around $50 trillion. The GDP is about $21 trillion. The indicator is about 230% (50 divided by 21).

If we compare the current ratio against its historical levels, right now it is significantly higher than the previous peak attained during the Dotcom bubble.  This means that the US stocks market is valued significantly above its historical norm.

Source: Advisorperspectives.com 

It is not hard to see why. The valuation of US stocks has been rising non-stop since last March. Many called it a ‘valuation expansion’. According to some metrics, the US stock market is valued at its highest in two decades (see below).

This means the investors are very optimistic about the future. Accordingly, they are paying a high price to own a future stream of corporate profits.

Source: Yardeni.com

What about the global version of the Buffet indicator?

To calculate this we sum up all the stock market values and the GDP figures of each country. Fortunately, in this age computers can do that for us quickly.

According to Bloomberg, the ratio is now back to the peak in 2007. The ratio is at 125%, the level before the global stock market topped out the last time (see below).

One more interesting fact. Just nine months ago, during the depth of the pandemic first wave, the ratio sat at just 70. The tremendous rally over the past few months pushed this ratio to new cyclical highs.

Paradoxically, stock markets are soaring even though the covid-19 pandemic is still ravaging societies around the world.

Source: Bloomberg

Will 2021 be a ‘Bubble Year’?

In light of these extremely high valuations, some old-timers are wary of buying the market. Jeremy Grantham of GMO is one. In fact, he thinks we’re in a ‘late-stage bubble’.  If you haven’t read his latest article (‘Waiting for the last dance’), I urge you to do so. Better still, print it out and hang it on your wall.

“The long, long bull market since 2009,” he observed, “has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, frenzied issuance and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along the South Sea Bubble, 1929, and 2000.”

Who can argue with that when we glance at Bitcoin’s chart? Or Tesla. Or small caps.

The spectacular capital flow into the riskiest segments of the market – small and micro caps – is a strong signal of speculative ‘animal spirits’. Look at the Russell 2000 ETF (IWM). Its vertical rise over the turn of the new year is stronger than any other periods since 2000.

In fact, capital has retreated from the large-caps FAANGS into these small caps. This is an indication that investors are taking on more risk, ie, moving up the risk curve.

What should one do based on the Buffet Indicator?

Navigating the stock market during the bubble years can be fun. Well, only if you invest in the right sectors. Right now, the asset price boom is seen among cryptocurrencies, tech, EV – among others. Growth sectors mostly, but soon this will spillover into other ‘old’ sectors, such as commodities and mining.

Did you know an electric vehicle requires 5x more copper? Unsurprisingly, copper is at its highest level since 2012. Rhodium is at all-time highs, too. All this means that the mining sector is moving up rapidly. The UK has plenty of these miners and so one should dip in here.

When the market is booming, transactions and trading volume go through the roof. Brokers benefit. Thus the financial sector is rising sharply in the US. Not so in the UK because the City is battling Brexit and a lack of bubbly sentiment. Look at Goldman Sachs’ (GS) share price, up 50 percent in the last three months to close at new highs.  In contrast, Barclays (BARC) share prices are still way below its 2011 lows.

What about bonds?

In a late-stage bubble, bond prices (which you can buy through bond brokers) are likely to go down because the central bank may want to cool things down. And the first thing they do is to raise interest rates. This time, they will just turn off the QE tap and asset prices are likely to come tumbling down.

Already, US long-maturity bonds are sliding. Take the iShares 20-year Treasury ETF (TLT). It broke down beneath key support recently as the 10-year Treasury yield surged above 1%.

In a nutshell, we have all seen this movie before. During a bubble, stock prices can go up and up. Overvalued, yes. But that will not prevent assets from becoming even more overvalued.

Join the bubble, but only risk what you can afford to lose.

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