The Buffett Indicator and Its Role in Market Forecast
People often marvel at the sheer investing deftness of Warren Buffett, who has distinguished himself as one of the most capable value investors of our times. Legend has it that he has a hint of divine wisdom about him when it comes to the stock market, a trait quite befitting his title, “The Oracle of Omaha”!
Be that as it may, his insight and experience in dealing with Wall Street businesses is what enabled him to develop his own financial metric called “The Buffett Indicator”. Over the years, this indicator has become the yardstick for measuring the performance and outlook of the stock markets and the economy at large.
Let’s see what exactly is the Buffett Indicator and how it has come to shape economic forecasts.
The ABCs of the Indicator
The Buffett Indicator is the ratio of the stock market capitalisation of a country to its GDP. It became popular after Buffett mentioned it in an article he wrote in 2000, calling the indicator “probably the best single measure of where market valuations stand at any given moment”.
The numerator of this ratio, or the market cap, is essentially the sum total of the value of all publicly traded stocks in a country. The denominator is the GDP figure calculated quarterly, biennially or annually.
The ideal value of the Buffett Indicator is 1, or equated values at both sides of the ratio. Here’s why: A country’s stock market capitalisation is the aggregate value of all future earnings of its listed stocks. Similarly, GDP is the monetary value of all final goods and services produced in the country. So, hypothetically, if every single economic activity in the country were corporatised, GDP would be numerically identical to the aggregate annual turnover of the companies, i.e., aggregated market cap.
Consequently, a higher ratio (greater than 100%) indicates that the market is overvalued, suggesting that stock prices may be too high compared to the value of their underlying businesses.
Past and Present Pit-stops of Overvaluation
The issue with overvaluation is that sooner or later, if the index and the equity value do not fall into the equation, then a crash is imminent. This is what happened during the dot-com bubble of the early 2000s when excessive speculation over internet companies pushed the Buffett Indicator close to 200%, which was imminently followed by the popping of the bubble.
History seems to be repeating itself as the current value of the Buffett Indicator is somewhere north of 180% which is alarming close to the early 2000 levels.
Market analysts believe that we are witnessing the culmination of multiple factors, all of which are heading towards a possible bursting of the bubble, again! Let us look at some of these factors which have seemed to drive up the Buffett Indicator currently.
One, increased listing in the market — Translation: IPOs. A hallmark of the technology bubble in the late 1990s was the average 500 public market debuts each year from 1995 to 1999. Guess what, even in 2020, there were 538 IPOs, 248 of which were SPACs, or blank-cheque companies which are anyway inflated in their stock prices previous to merger or acquisition of businesses.
Consider Saudi Aramco, for instance. On December 11th 2019, Saudi Arabia’s stock market capitalisation tripled overnight after Aramco’s $1.7trn IPO launch, which was valued at twice the country’s GDP (roughly $900bn).
Two, the Tech Bubble — The S&P market-cap is at an all time high, and what’s worse, it’s concentrated on the top five tech companies’ stock behaviour (Apple, Microsoft, Amazon, Tesla and Facebook). Investors are jumping on the same momentum bandwagon by putting too many of their eggs into one basket, so to speak!
Three, the Price-to-Earnings (P/E) Ratio: According to FactSet data, the S&P 500 index is now trading at 18.6 times forward earnings. Stocks of individual companies like Snowflake, MicroStrategy, and of course, GameStop are grossly overvalued, meaning that their financials do not support the bullish surge in stock prices.
Jeremy Grantham, a notable investor, also attributes this bullish run to “crazy investor behaviour” like that of Elon Musk whose tweets on companies like Signal, GameStop and Dogecoin have jacked up their values in meteoric fashion. In fact, critics have long alleged that Musk’s own company Tesla’s valuation defies analysis in a major way. Each car sold annually represents a staggering $1.25m of market cap for Tesla compared to just $9,000 per car for General Motors!
FYI: Nobel laureate Rober Shiller’s inflation-adjusted P/E assessment of S&P 500 companies shows the current figures following the same trajectory as they did two decades ago prior to the dot-com crash.
Four, the pandemic-orchestrated economic downturn. Consumer spending is witnessing record lows and GDP numbers have turned negative in certain countries. Thanks to the lockdowns, growth figures have contracted too low to balance out the market values of corporate assets.
How Reliable Is This Indicator?
Of course, no single metric is illustrative of the entire market. The most glaring shortcoming of the Buffett Indicator is that it doesn’t take into account the state of non-equity asset markets like bonds, real estate, commodities etc.
Bonds represent a lower-risk alternative to equity assets and the two have a very independent dynamic. Bonds, in turn, have a direct relationship with interest rates, which play a major role in companies’ ability to borrow cheaply and finance growth. So higher interest rates ultimately lead to lowered stock values and vice versa.
The Buffett Indicator has maintained higher levels since the last 30 years, which has led to differing opinions on what should be its optimum value. Some say it’s 75% while others believe it’s 100% or higher considering the “new normal” levels.
Finally, what about private companies? In a country like India which boasts of a large MSME sector consisting of companies whose stocks aren’t listed on the exchange or publicly traded, would you undermine their capital and contribution to the GDP and economy at large? Don’t think so!
The Indian Indication
As of January 28th 2021, the Buffett Indicator for India is around 70%, which is closer to our long-term ratio of around 75%. A year ago, the ratio was 92% and three years ago it was 134%. Our 2021 P/E was at 27.1x and our share in the global market cap is now at 2.4% while our share of the global GDP is almost 7%.
The indicator has rarely crossed 100% because of our increased reliance on the unorganised (aka unlisted) sector. Data from Economic Times showed that nearly half of Nifty companies are currently trading at a discount (e.g. Coal India, NTPC, ONGC, IOC, ITC etc.)
Although we have crossed quite a few market milestones recently (The 50K mark, BSE breaking into Global Top 10 etc.), there are a few things to remember. The composition of our stock market is quite dissimilar from the composition of the economy. Agriculture contributes over 15% to our GDP which is an under-represented entity in the markets. Private capital is easily available too, which is why most of the companies prefer not to enter the listed universe. Moreover, US households allocate about 35% of their financial savings to stocks but RBI data says that in India, the number is as low as 6%. This imbalance in equity allocation by Indian households suggests a huge gap between the stock market and the economy.
So, it is fair to say that judging by the Buffett Indicator, Indian markets are at best under-developed, if not undervalued. Perhaps wiser not to apply the indicator as a thumb rule to India. In any case, more analysis needs to be done to gauge the Buffett Indicator’s application for valuation of markets in this country and those around the world.
(Originally published February 15th 2021 in transfin.in)
