In a 2001 interview in Fortune, Warren Buffett made his case for a particular stock market valuation indicator, saying “it is probably the best single measure of where valuations stand at any given moment.” While he may be correct—it may be the best stock market valuation tool around—it has some glaring flaws.
In this post, I will briefly explain the problem and ask for your help.
The indicator of which I speak compares total U.S. stock market cap to GDP. Here is the formula:
U.S. Stock Market Valuation = Total U.S. Market Cap / GDP
Market cap is derived from the Federal Reserve’s Statistical Release Z.1, Financial Accounts of the United States, Table B.103, line 41. Since this is not published daily, the Wilshire 5000 is a suitable replacement.
The presumption is that stock prices cannot continue to rise at a faster rate than the underlying economy. This assumes there is a strong correlation between the economy and economic growth. The correlation between the S&P 500 Index and GDP (SAAR) from April 2, 1962 through December 31, 2015 is 22.4%. This indicates a random correlation.
When you look at how this correlation has changed over time, it ranges from a positive 93.4% to a negative 93.7%. Hence, during short-term periods, the correlation varies widely. Stock prices are a key factor of market cap and are affected by profits, which are linked to the health of the economy.
The Problems With the Indicator
There are two primary issues with this valuation methodology. They are:
1) Stocks can remain undervalued or overvalued for long periods. This makes it difficult to use this tool as a signal for when to get in or out of the market.
2) U.S. companies are deriving more revenue from overseas.
To address the second point, if U.S. companies derived all of their revenue from within our borders, the valuation tool would be more accurate. Two changes would make this valuation tool more useful. First, reduce total market cap by the amount of revenue derived overseas. Second, remove net-exports from U.S. GDP. This would result in a purely domestic valuation indicator without foreign interference.
I realize there are other valuation tools such as Tobin’s Q and Shiller’s CAPE Ratio, both of which I have not closely analyzed. Here is my question for you: Can you recommend a better stock market valuation tool? If so, would would you tell us, and tell us why it’s better?
Until next time, thanks for reading and have a great week!