In today’s Finshots, we talk about the famous Buffett Indicator and why it may not always predict stock market crashes or draw a fair picture of the economy.

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The Story

India’s stock market capitalisation hit the $5 trillion milestone (roughly ₹416 lakh crores) this week. We’re talking about the market value of all companies that have their stocks listed on the BSE (formerly Bombay Stock Exchange).

And that’s quite an achievement because just about 6 months ago it was at the $4 trillion mark.

But this milestone seems to be worrying analysts. They’re saying that this could be a sign of overvalued or expensive markets. How do they know that?

Well, they looked at some important metrics.

Take for instance, the forward P/E (price-to-earnings ratio). It’s the ratio you get when you combine the current share prices of all listed companies and divide it by the sum of their estimated earnings per share (EPS) over the next 12 months.

Now, if you’re unfamiliar with EPS, think of it as the profit that a listed company makes for every share that its shareholders own. Just that with forward P/E you don’t go by the company’s EPS based on its actual profits. You go by forecasts of the future profits instead.

And this metric is moving in one direction and that’s upwards. For context, the number of companies whose stock prices are trading at over 50 times their forward P/E multiples has increased 10-fold over the past decade. It simply means that these stocks are 50 times more expensive than the estimated earnings they’ll generate over the next year. That could be sign of an overvalued market.

Then you have something called the Buffett Indicator, the protagonist of our story. You’ve probably guessed by its name that it’s an indicator coined by Warren Buffett, Berkshire Hathaway’s CEO and someone you often think of when you discuss investing. Buffett proposed this indicator way back in 2001 and even called it “probably the best single measure of where valuations stand at any given moment.”

So what’s it about, you ask?

Well, it’s pretty simple. The Buffett Indicator is the market capitalisation seen as a percentage of the country’s GDP (Gross Domestic Product) or the value of all the goods and services the country produces.

To put things into perspective, let’s assume that the market value of all listed stocks is ₹100 and that the value of all goods and services a country produces is also ₹100. Then, the Buffett Indicator will be 100% or 1 (or ₹100 divided by ₹100). This means that the market capitalisation and GDP are the same and that stocks are fairly valued. On the flip side, if stock prices rise faster than the GDP, it could potentially be foreshadowing a stock market bubble. And stock prices nosediving below the GDP could mean that the markets are cheap, signalling a buying opportunity.

And guess what the Buffett Indicator says about India’s stock market right now?

It’s at 154%* and the highest we’ve seen since May 2007.

Now before you panic and think of withdrawing all your stock market investments, here’s something you must know.

The Buffett Indicator may be a metric you could look at when you make your investment decisions. But is it really reliable or foolproof for that matter?

Well, research by YCharts, an investment research firm, sort of tried to look for an answer to this question. So it drew up data for the US stock markets and crunched the numbers to see how accurately the Buffett Indicator predicted stock market crashes since 1971.

And here’s what they found out. If you looked at major market declines in the US since 1971, this indicator gave warning signals ahead of 50% of them. But if you came further and looked at data since 2000, then the Buffett Indicator successfully predicted about 57% of the major market declines.

And while they concluded that the indicator provided well timed warnings of market declines, here’s the catch.

YCharts made some tweaks and came up with a threshold that was more suitable for the markets of the 21st century. So instead of saying that markets were overvalued when the Buffett Indicator touched 100% or more, they adjusted that to about 132%.

Even if you went by that and exited your investments from the S&P 500 (or an index that tracks 500 leading publicly traded companies in the US) you’d have avoided four major market declines of 10% or more. But would have still missed out on about 10% of the annualised returns until June 2022. In fact, it wouldn’t even give you a heads up before the decline during the Global Financial Crisis!

So why doesn’t the Buffett Indicator get it right every time?

For starters, the metric itself may be a little flawed. Just think about it. The GDP of a country is something that you look at over a period. It measures past economic activity for one quarter of a year or the entire year.

But that’s not how market capitalisation works. Stock market prices move on the basis of expectations of future performance. This simply means that if a company has the potential to give you better earnings because it has bagged a big project or contract, its stock will move up. The opposite will happen if something dents the company’s ability to do well in the future. So with the Buffett indicator, you’re not really measuring two parameters that consider the same time frame. And if you give this further thought, you’ll see that forward P/E does this job pretty well.

But you could argue that profits derived from the stock markets are a factor of the GDP simply because GDP depends on production of goods and services which in turn depend on land, labour, capital and entrepreneurship. Land earns rent, labour earns wages and capital and entrepreneurship earn interest and profits. When you put rent, wages and profits together, you get GDP. And stock market capitalisation does depend on atleast one of these components ― profits.

So it might not actually be like comparing apples and oranges.

But here’s the thing. The Buffett Indicator doesn’t consider the effect of global operations on stock markets. Let’s explain. Imagine that you kickstart a company in India and list it on the stock market. In a few years, you open several global branches too. That drives up the value of your stock in the country.

Does it affect India’s GDP, though?

No.

That’s simply because GDP only measures the value of goods and services produced within its borders. So that could again derail the objective of the indicator.

And it doesn’t stop there. The Buffett Indicator was coined with the US markets in mind. So it assumes a strong relationship between stock market performance and economic growth. But that may not make much sense in the context of the Indian economy.

If you’re wondering why, just think about the percentage of households investing in the stock markets in both countries. Over 58% of households own stocks in the US. While that figure is just about 17% in India. One market is mature. The other one is getting there. And market behavior in the these two scenarios can vary considerably.

So yeah, no indicator can reliably tell you if the stock market is collectively overpriced or not. If it could, then nobody would lose money in the markets, would they?

Until next time…

*As of 21st May 2024

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