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Buffett Indicator - The Percent of Total Market Cap Relative To Gross National Product
Buffett Indicator - The Percent of Total Market Cap Relative To Gross National Product
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20T
1. Interest rate
100%
Interest rates “act on financial valuations the way gravity acts on matter:
The higher the rate, the greater the downward pull. That's because the 75%
rates of return that investors need from any kind of investment are directly
tied to the risk-free rate that they can earn from government securities. 50%
So if the government rate rises, the prices of all other investments must
adjust downward, to a level that brings their expected rates of return into
25%
line. Conversely, if government interest rates fall, the move pushes the 1980 1990 2000 2010 2020
prices of all other investments upward.”—Warren Buffett
2. Long Term Growth of Corporate Profitability The Predicted and the Actual Stock Market Returns
Over the long term, corporate profitability reverts to its long term-trend,
which is around 6%. During recessions, corporate profit margins shrink,
and during economic growth periods, corporate profit margins expand.
However, long-term growth of corporate profitability is close to long-term
economic growth. The size of the US economy is measured by Gross
National Product (GNP). Although GNP is different from GDP (gross
domestic product), the two numbers have always been within 1% of each
other. For the purpose of calculation, GDP is used here. The U.S. GDP
since 1970 is represented by the green line in the first of the three charts
to the right.
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3/14/2020 Buffett Indicator: The percent of total market cap relative to Gross National Product?
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3. Market Valuations
TMC/GDP=40%
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Over the long run, stock market valuation reverts to its mean. A higher TMC/GDP=120% 30%
current valuation certainly correlates with lower long-term returns in the Actual Return
2Y Treasury Yield%
future. On the other hand, a lower current valuation level correlates with a
20%
higher long-term return. The total market valuation is measured by the
ratio of total market cap (TMC) to GNP -- the equation representing
10%
Warren Buffett's "best single measure". This ratio since 1970 is shown in
the second chart to the right. Gurufocus.com calculates and updates this
ratio daily. As of 03/14/2020, this ratio is 124.9%. 0%
We can see that, during the past four decades, the TMC/GNP ratio has
-10%
varied within a very wide range. The lowest point was about 35% in the
previous deep recession of 1982, while the highest point was 148%
during the tech bubble in 2000. The market went from extremely -20%
1980 1990 2000 2010 2020
undervalued in 1982 to extremely overvalued in 2000.
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3/14/2020 Buffett Indicator: The percent of total market cap relative to Gross National Product?
1. Business growth
If we look at the overall economy, the growth in the value of the entire
stock market comes from the growth of corporate earnings. As we
discussed above, over thelong term, corporate earnings grow as fast as
the economy itself.
2. Dividends
Although the value of a business does not change overnight, its stock
price often does. The market valuation is usually measured by the well-
known ratios such as P/E, P/S, P/B etc. These ratios can be applied to
individual businesses, as well as the overall market. The ratio Warren
Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio
of the economy.
Putting all the three factors together, the return of an investment can be
estimated by the following formula:
The first two items of the equation are straightforward. The third item can
be calculated if we know the beginning and the ending market ratios of
the time period (T) considered. If we assumed the beginning ratio is Rb,
and the ending ratio is Re, then the contribution in the change of the
valuation can be calculated from this:
(Re/Rb)(1/T)-1
This equation is actually very close to what Dr. John Hussman uses to
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3/14/2020 Buffett Indicator: The percent of total market cap relative to Gross National Product?
calculate market valuations. From this equation we can calculate the
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likely returns an investment in the stock market will generate over a given
time period.
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▾ Enter calculation,
Ticker, the time
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Go we used was 8 years, My Portfolios ▾ My Gurus ▾ Get 7-Day Free Trial
which is about the length of a full economic cycle. The calculated results
are shown in the final chart to the right. The green line indicates the
expected return if the market trends towards being undervalued
(TMC/GNP=40%) over the next 8 years from current levels, the red line
indicates the return if the market trends towards being overvalued
(TMC/GNP=120%) over the next 8 years. The blue line indicates the
return if the market trends towards being fair-valued (TMC/GNP=80%)
over the next 8 years.
The thick bright yellow line in the bottom right chart is the actual
annualized return of the stock market over 8 years. We use "Wilshire
5000 Full Cap Price Index" to do the actual return calculation. We can
see the calculations largely predicted the trend in the returns of the stock
market. The swing of the market’s returns is related to the change in
interest rates.
It has been unfortunate for investors who entered the market after the late
1990s. Since that time, the market has nearly always been overvalued,
only dropping to fairly valued since the declines that began in 2008. Since
Oct. 2008, for the first time in 15 years, the market has been positioned
for meaningful positive returns.
Based on these factors, Warren Buffett has made a few market calls in
the past. In Nov. 1999, when the Dow was at 11,000, and just a few
months before the burst of dotcom bubble, the stock market had gained
13% a year from 1981-1998. Warren Buffett said in a speech to friends
and business leaders, “I'd like to argue that we can't come even remotely
close to that 12.9... If you strip out the inflation component from this
nominal return (which you would need to do however inflation fluctuates),
that's 4% in real terms. And if 4% is wrong, I believe that the percentage
is just as likely to be less as more.”
Two years after the Nov. 1999 article, when the Dow was down to 9,000,
Mr. Buffett said, “I would expect now to see long-term returns run
somewhat higher, in the neighborhood of 7% after costs.”
"Nine years have passed since the publication of the article of November
22, 1999, and it has been a wild and painful ride for most investors; the
Dow climbed as high as 14,000 in October 2007 and retreated painfully
back to 8,000 today." Warren Buffett again wrote in Oct. 2008: "Equities
will almost certainly outperform cash over the next decade, probably by a
substantial degree."
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