The Warren Buffett indicator suggests that the US stock market is in bubble territory.
In this post, I’ll discuss what exactly the Warren Buffet indicator is based on historical averages, which the stock market considers quite overvalued.
In a brief, at any given point, the buffet indicator is used to determine how cheap, and expensive it is.
Table of content
- What is the Buffett indicator?
- How the Warren Buffett indicator works
- How extreme the buffet indicator is?
- What does this mean for future investment returns?
- How can we protect our investment
- Conclusion
- Is Buffett indicator reliable
What is the Buffett indicator?
Source: ( Wikipedia ) appears that
In 2001 legendary investor Warren Buffett create his indicator.
Buffett and I quote
“Probably the greatest single measure of where evaluation stand at any given moment”
It compares the US Wilshire 5000 index with the US GDP. it’s used by the financial media and investors as a valuation benchmark for the U.S. entire stock market.
shows the ratio between the U.S. gross domestic product and the total stock market capitalization and gives a numerical total value of how cheap or expensive the total stock market is at a given time.
How the Warren Buffett indicator works
The Buffett indicator is the ratio of the total U.S. stock market valuation to the GDP, or more simply, the total value of all U.S. stocks divided by the total size of the U.S. economy.
The ratio calculated by 2 parameters
1. Metrics total stock market value
2. Gross domestic product (GDP)
Market Cap to GDP Ratio = ( Value of all public stocks in the country / The GDP of the county) x 100
Value of all public stocks in the country
To determine the total stock market value of the United States, Buffett uses the Wilshire 5000 Index. the index weighted by market capitalization, consisting of 3451 publicly traded companies.
Wilshire 5000 index – (Buffett Indicator)
The Wilshire 5000 Index measures the total value of the U.S. stock market,
it serves as a benchmark for the entire U.S. equity market.
People considered it to be the best single stock,
with which you can measure the entire U.S. stock market.
the value of the index would make the Buffet indicator lower.
the current market capitalization of the Wilshire 5000 is approximately $37.3 trillion.
The gross domestic product of the county
The next parameter we need for our calculation is the gross domestic product. (GDP)
It’s calculated quarterly by the U.S. government’s Bureau of Economic Analysis,
Gross domestic product is a static measure of past economic activity and represents the total output of the U.S. economy.
it contains no predictions about the future and no expectations or estimates about future economic activity or growth.
the current GDP of the United States is $25.6 trillion.
GDP is calculated and published quarterly, several months late so that at the time of publication, data are available for a quarter that occurred several months earlier. The Federal Reserve Bank of Atlanta publishes GDP, an estimate of the current quarter’s GDP growth rate, from which an estimate of the current month’s GDP value (annualized) of $25.8 trillion can be calculated. A historical graph of GDP is shown below.
The result of the formula is 150. Multiply this number by 100 to convert it to a percentage.
This means that the famous Buffet indicator is 150%
How extreme the buffet indicator is?
The important question is: Is it high? Is it low?
Without historical context, this figure is useless.
Take a look at this chart I found at (www.longtermtrends.net)
What is the Buffett indicator today
This basic chart shows a historical trend line and can give us a general idea of where the market was at a particular time.
Let’s compare it to historical averages, Look at how extreme the Buffet indicator is right now.
Buffett’s indicator currently the state is 150%, Looking at the graph shows, that the current position is much higher.
relatively, if it turned out to be a huge market bubble in the past.
Look at the peak of the famous .com bubble in March 2000.
The average value of the Buffett indicator was around 85%.
Buffett quote from 2001:
“If the percentage relationship falls to the 70 or 80 area buying stocks is likely to work out very well for you, if the ratio approaches 200 as it did in 1999 and in 2000 you are playing with fire”
If the indicator shows a high number, it could mean that the shit is hitting the fan
and after everything collapses, the number falls below its historical trend line.
Always remember the Buffett indicator:
70 to 80 percent is a good rating, 130 percent is a neutral rating, and 200 percent is bad.
What does this mean for future investment returns?
As we are in a cycle, and it seems that we are heading for a downtrend, many value investors expect poor returns for the coming future.
You’re probably wondering where we’re now, is really high, or whether we’re in for a shit storm.
Whether it’s low and the markets seem to be fairly valued.
With a success rate of only 50%, the “Buffett Indicator” is one of the most reliable.
Take a closer look at the chart the “Buffett indicator” has been over 120% for a quite long time
which means that stocks have been overvalued by this metric for about six years.
the average returns of the s&p 500 were extremely high, averaging 10% per year.
the Buffet indicator sometimes helps predict future returns in the stock market.
No one can predict the future, and market timing is a loser’s game. making predictions about the stock market.
The chart shows that in some cases, the Buffet indicator makes accurate predictions about the future returns of the stock market.
his expectations for market valuation over the long run stock market valuations tend to revert to their historical averages.
A higher valuation is certain to correlate with lower long-term returns in the future,a lower current valuation level correlates with higher long-term returns.
How can we protect our investment?
Let’s use a warren Buffett quote
“interest rates act like gravity on stock prices”
As interest rates rise stocks become less valuable and as interest rates decrease stock prices increase. You can survive the turbulences of the market, Just follow those rules.
First Rule
Think about your retirement plan, as you are a co-owner of a bunch of great companies,
The only reason you bought them is that they were cheap.
those prices will be higher in the future.
Second Rule
Use the dollar cost averaging method for your investing,
invest in the market no matter how bad it looks and no matter what the Buffett indicator looks like,
even with all the doom that’s coming our way, keep buying good companies.
As you learn more about value investing, you can see this recession as one of the greatest things that could ever happen.
buy some more of your favorite companies with great balance sheets at even better and cheaper prices.
Third Rule
I’d urge you to do is to learn a process and separate a stock price and a company – those are two completely different things.
always remember that some people think that a company’s stock is phenomenal,
by a closer look at the underlying physical company is garbage.
If you don’t want to buy individual shares and just want to buy the market like an ETF.
Conclusion
My experience taught me,
a downturn in the market can be one of the best things that ever happened to your portfolio.
it gives you a unique opportunity to buy these great companies at even better prices.
Reminder, no single metric can define and predict where the stock market is headed,
I beg you, please don’t make rash decisions based on that data.
This isn’t meant to be advice or a call to action.
This a fair warning that the data shows we could be in trouble.
The Buffett indicator has been a good gauge of future stock market returns.
The indicator provided a warning signal of market declines with this increased threshold. The average time between the first overvaluation signal and the relative peak of the S&P 500 was about 13 months shorter.
Each warning signal precedes represent one major market decline.
In my opinion, this is an extremely strong indicator that you can use as a good strategy to buy or sell.
Is the Buffett indicator reliable
The logic behind this indicator is that a country’s GDP gives us hard, down-to-earth information about the country’s economy, while market valuation is very subjective. So by linking market capitalization to GDP, we can objectively assess whether valuations are appropriate or not.
In other words, this indicator is used to assess whether the stock market as a whole is overvalued or undervalued. The higher the value of the Buffett indicator, the greater the probability that the markets are overvalued.
So it’s fair to say that the Buffett indicator gives a pretty good overview of market valuations, and it’s no wonder that fund managers around the world use this indicator to decide whether to enter or exit the market.
if you enjoyed this post make sure to read more about how to become a better investor.
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