The Buffett Indicator

WarrenBuffettby Cato   8/20/14
Warren Buffett remarked to Fortune magazine in 2001 that the ratio of market capitalization (MC) to gross domestic product (GDP) “is probably the best single measure of where valuations stand at any given moment.”

Warren’s goal is shared by all investors: find a way to know when the prospects in the markets are good to make new investments; when the risks are in our favor and markets are relatively cheap.  Also when the risks are not in our favor and it’s time get defensive.  Warren is the king of buying low and just as importantly the monarch of not buying high.  His indicator is worth understanding not only for its financial insights but for the economic and political implications as well.

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This is the standard graphic you will see.  Since ‘no tree grows to the sky’, the higher the valuation multiple the more likely it is the market will fall than rise in the future.  That’s Warren’s theory.  This is based on the idea that all markets “revert to the mean” … that all markets cycle around some central valuation and will fall back to that mean eventually after a long rise, or rise up to the mean after a long drop.  That is Warren’s thinking anyway and it’s shared widely.

Market Cap can be calculated as the market price of a security times the number of shares of that security in the marketplace.  Texas Instruments, for instance, has about 1.2 billion shares outstanding and the current price is about $46, so its MC is about $55 billion.  Add up the MC’s of all corporate equities and you have the rough “valuation” of the for-profit business sector of America’s economy.

GDP is not a perfect metric for the broader American economy.  But it’s a good approximation, it’s been tracked for decades, and its flaws are widely understood.

Divide MC by GDP and you get the graphic above, reaching back 65 years.  The market peaks in 2000, 2007 and today are clearly visible, as is what came after 2000 and 2007.  Is that what is coming again?

There are two major problems with this MC/GDP metric (and a few minor ones but we will stick to big ones here).  The first is distortion from the calculation itself.  The second is distortion from inflation.

The solution to the first problem is to use a logarithmic instead of a linear scale.  This removes the math distortion, so that all 50% increases and decreases on the graphic are exactly the same distance up and down the grid.

2014-03-08-DJIA-2-copy

Visually, this creates a better image of the relative movement of the ratio over time.  On a log scale this, above, is what the 100 year graphic looks like.

The second major issue is inflation.  Removing inflation from the log scale graphic above reveals the real, purchasing power changes in the markets.  And it reveals something else, too.  It shows clearly how difficult it is to make real gains in wealth, gains that lead to a rise in living standards.  Markets take way what they give, as they “revert to the mean”.

To understand the distortion inflation creates, focus on the five points in the graphic above between 1965 and 1982 where the Dow Jones average was nominally at 1000.  Looking at this graphic, one would judge that one could break even over this 17 year term if one just held a market index fund.  You’d make nothing, true, but you’d lose nothing either.

Below is the 100 year graphic adjusted for inflation.  Compare this one to the same one, unadjusted for inflation, above.  See what I mean?

2014-03-08-DJIA-4-copy

Note the same five “Dow 1000” points.  Different picture altogether.  The losses in purchasing power were huge because inflation was high.  And this distortion is common where inflation is not adjusted out.  It distorts decisions.  Perceptions, too.  A 6% salary increase isn’t good news if inflation is running at 8%, is it?

Here’s the payoff.  The real, inflation adjusted losses in the 1965 to 1982 bear market wiped out all the real gains from 1950 to 1965.  The real losses in the Great Recession of 2008-09 wiped out all the gains from 1995 to 2007.  This is what Warren knows that seems to make him prescient.  He knows the inflation-adjusted, log scale reality of investing.

All the news is not bad, of course.  The “Reagan Revolution” economy of 1982 to 2000 created an enormous increase in real market valuation.  And this last graphic, well considered, leads to the questions we investors are asking right now.

Is today’s market, after 14 years of essentially sideways motion and two big drops, ready to soar?  Or will that “reversion to the mean” kick in again, taking the market back to 2009 levels for a second time?

Think even longer and deeper.  Have we reached a new, permanently higher plateau of valuation, the bounds of which were established between 1995 and 2000 and 2003 and 2009 and 2014?  Is the right one-third of this graphic, from 1995 to 2014, the new normal?  The implications if it is are staggeringly good, yes?

Or will we “revert” to the levels of valuation on the left two-thirds of that graphic, within bounds established between 1915 and 1932 and 1965 and 1982 and 1995?  The implications of a reversion to that prior, 20th Century mean are staggeringly bad, are they not?

Now think economics and politics.  What Federal Reserve practices and federal government policies created the 17 year “malaise” in the markets between 1965 and 1982.  What practices and policies created the conditions that led to the boom years of 1982 to 2000?  What practices and polices have resulted in the boom and bust “sideways” markets of 2001 to 2014?

And this is the big question:  What will be the practices and policies that are most likely to be followed in the future?

What should we do to create a “Roaring 2020s” … another 1980’s and 1990’s economic expansion and market bull?  How likely is it that our politics will bring those beneficial practices and policies into being?

These are not idle questions.  Answer them correctly and invest accordingly … it doesn’t matter whether you’re bullish and optimistic or bearish and pessimistic on this point, just be right and put your money where your mouth is … and in 10 or 15 years you’ll be as rich as Warren.


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One Response to The Buffett Indicator

  1. Timothy Lane says:

    One thing to note is that the market can and does create wealth in general — but it’s the free market of businesses producing goods and services. The stock market is a great game for those who can afford it, and some can work out ways to do well by studying it carefully, but for most people its benefits are more doubtful. I gather that the best investments are simply in exchange funds.

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