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Portfolio > ETFs > Broad Market

Under the Hood: Stock Market Valuation, Pt. 1: Buffett’s Choice

By Mike Patton

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There seems to be considerable disagreement about the level of the stock market these days. Is it over valued? Undervalued? Correctly valued? How do you tell for sure?  In this two-part series, we’ll take an in-depth look at the most popular stock market valuation tools. We’ll look at the date of origin and the level of predictive value for each. In this article, we’ll begin with Warren Buffett’s preferred measure, Total Market Cap to GDP. 

Total Market Cap to GDP

This particular valuation method received high praise from Warren Buffett in 2001 in an interview with Fortune magazine. In the article, Mr. Buffett remarked, “…it’s probably the best single measure of where valuations stand at any moment.” Let’s examine when it began, how it work, and how reliable it is with respect to signaling when the stock market is at its peak or primed for a decline. 

This stock market valuation tool was first released in December 1970. It uses the total stock market capitalization in the numerator and GDP in the denominator. Total stock market capitalization is equal to the share price of all publically listed securities multiplied by the total number of shares outstanding. The market cap to GDP valuation ratio is expressed as follows:

((Total Stock Market Capitalization / GDP) x 100) = Stock Market Valuation % 

This ratio utilizes the Wilshire 5000 Stock Index which is the most comprehensive index for U.S. stocks. This is also Wilshire’s flagship index and includes all public companies trading on U.S. exchanges and for which price data is available. (Here’s a link to an interactive chart for the Wilshire 5000 index as published on the St. Louis Fed’s site).

It’s important to properly interpret the ratio but that’s where things get hazy. Even though this ratio provides insight into the market’s valuation at a given point in time, because trading is done by humans, there is also an emotional component which this and most other ratios fail to include. Because humans prefer concrete metrics over the abstract, we tend to approach this and other measures from a logic  point of reference. In reality, the aspect of human behavior plays a significant role, rendering black-and-white interpretations somewhat obsolete. All of this reminds me of a trading maxim which says: 

“The market can remain irrational longer than we can remain solvent.”–Anonymous

In other words, if we decide to make decisions based on this or some other rigid measure, we may miss out on a sizable amount of stock market upside. The reverse is also true, in that if we choose to ignore it, we will likely experience substantial losses. Therefore, it’s important to pay attention to it, but use your own judgment as to how it will influence your investment decisions. With this as a backdrop, let’s turn our attention to the ratio’s current reading and examine some periods in the past when it was flashing red.

Predictive Value

The key with any tool of this nature is its predictive value. However, as we have already discussed, because of the human element, this type of tool will not provide the user with the consistent and accurate indicator we desire. Even so, it is certainly useful and, with prudence, can serve as an excellent measure of the valuation of stocks.

The following chart shows how this ratio has changed since its inception on December 31, 1970.

To the right in the chart above we can see the current ratio is 124.90%. This is well above its long-term average of 76.82%. However, the most important line of division is 100%, the point at which stocks are considered fairly valued. In essence, a reading above 100% indicates an overvalued market while a lower reading indicates one which is undervalued.

Rather than providing a rigid interpretation, the ratio should be viewed in degrees and considered with ancillary data. This is partly because financial markets tend to over shoot on the upside as well as on the downside.

When we examine the following chart, we will see the truth of this statement.  

I have added a solid red line to indicate the level at which stocks are considered to be fairly valued. In addition, I have added three points (A, B, and C) corresponding to three major stock market corrections. For example, consider Black Monday which occurred on October 19, 1987 (Point A). This is still the largest single-day percentage drop in modern stock market history. Less than two months earlier, on August 25, 1987, the ratio peaked at 68.43%. Clearly, stocks were not in overvalued territory which bolsters the notion that this particular decline can be attributed to other factors.

Point B is on March 24, 2000 when the tech bubble burst. It was on that day that the ratio reached 148.50%, its highest point ever. This was also the day stocks peaked. Point C was the stock collapse during the housing bubble. The ratio peaked at 109.40% on June 4, 2007, before retreating to 98.07% slightly over two months later on August 15. When the market hit its peak on October 7 that same year, the ratio was back up to 108.50%, slightly below its level of 109.40% less than four months earlier. 

So why didn’t stock prices correct sooner during the tech bubble (or later during the housing bubble)? This is especially interesting since the most recent collapse occurred as the ratio was barely in overvalued territory at 108.50%. In fact, the ratio even fell below 100% for a short time between its peak in June 2007 and the market’s top in October 2007. In addition, today’s ratio of 124.90% is much higher than it was in 2007, but is still below the level reached during the tech bubble. Does this warrant concern? Is there another big bear lurking around the corner? 

Conclusion

Although we would prefer an accurate and highly predictable market valuation measure, is it really possible? If the past is any indication, the answer would seem to be no. With today’s ratio close to 125%, should we be concerned? I believe this is a question with an answer, but an answer which has no absolute.

When will the next top be reached? It depends on the human element. How long will investors continue to buy U.S. stocks? Given the current state of other assets classes such as cash, bonds, foreign stocks and bonds, and commodities, this time the ratio may exceed the level it reached during the tech bubble. In other words, this may be the greatest Federal Reserve-induced bubble of all time. Are the lights flashing red today or only yellow? Red or yellow, they are certainly not flashing green.

Therefore, it would be prudent to give careful thought to your investment decisions and beware of the next correction. After all, it’s not a question of “if” but “when.” 

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