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Market Cap to GDP: An Updated Look at the Buffett Valuation Indicator

  • Written by Syndicated Publisher No Comments Comments
    July 25, 2016

    Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.”

    The four valuation indicators we track in our monthly valuation overview offer a long-term perspective of well over a century. The raw data for the “Buffett indicator” only goes back as far as the middle of the 20th century. Quarterly GDP dates from 1947, and the Fed’s balance sheet has quarterly updates beginning in Q4 1951. With an acknowledgement of this abbreviated timeframe, let’s take a look at the plain vanilla quarterly ratio with no effort to interpolate monthly data.

    The strange numerator in the chart title, NCBEILQ027S, is the FRED designation for Line 41 in the B.103 balance sheet (Market Value of Equities Outstanding), available on the Federal Reserve website. Incidentally, the numerator is the same series used for a simple calculation of the Q Ratiovaluation indicator.

    The Latest Data

    The denominator in the charts below now includes the Third Estimate of Q1 GDP. The latest numerator value is Q4 data from the Fed’s “Corporate Equities; Liability” extrapolated based on the quarterly change in the Wilshire 5000. The current reading is 119.0%, up from 112.9% for the Second Estimate. It is off its 130.9% interim high in Q1 of 2105 and remains under 2 standard deviations from its mean.

    Buffett Indicator

    Here is a more transparent alternate snapshot over a shorter timeframe using the Wilshire 5000 Full Cap Price Index divided by GDP. We’ve used the St. Louis Federal Reserve’s FRED respository as the source for the stock index numerator (WILL5000PRFC). The Wilshire Index is a more intuitive broad metric of the market than the Fed’s rather esoteric “Nonfinancial corporate business; corporate equities; liability, Level”. This Buffett variant is off its interim high of Q2 of 2015.

    Wilshire 5000 Version

    A quick technical note: To match the quarterly intervals of GDP, for the Wilshire data we’ve used the quarterly average of daily closes rather than quarterly closes (slightly smoothing the volatility).

    How Well do the Two Views Match?

    The first of the two charts above appears to show a significantly greater overvaluation. Here are the two versions side-by-side. The one on the left shows the latest valuation hovering at two standard deviations (SD) above the mean. The other one is noticeably lower. Why does one look so much more expensive than the other?

    Buffett Indicator Wilshire 5000 Version

    One uses Fed data back to the middle of the last century for the numerator, the other uses the Wilshire 5000, the data for which only goes back to 1971. The Wilshire is the more familiar numerator, but the Fed data gives us a longer timeframe. And those early decades, when the ratio was substantially lower, have definitely impacted the mean and SDs.

    To illustrate the point, here is an overlay of the two versions over the same timeframe. The one with the Fed numerator has a tad more upside volatility, but they’re singing pretty much in harmony.

    Two View Overlay

    Incidentally, the Fed’s estimate for Nonfinancial Corporate Business; Corporate Equities; Liability is the broader of the two numerators. The Wilshire 5000 currently consists of fewer than 4000 companies.

    What Do These Charts Tell Us?

    In a CNBC interview in 2014, Warren Buffett expressed his view that stocks aren’t “too frothy”. However, both the “Buffett Index” and the Wilshire 5000 variant suggest that today’s market remains at lofty valuations — still above the housing-bubble peak in 2007, although off its interim high in Q1 of 2015.

    Wouldn’t GNP Give a More Accurate Picture?

    That is a question we’re often asked. Here is the same calculation with Gross National Product as the denominator; the two versions differ very little from their Gross Domestic Product counterparts. Note that GNP runs a few months behind GDP, so these comparison charts are based on the second estimate of GNP for Q1.

    Buffett Indicator Wilshire 5000 Version

    Here is an overlay of the two GNP versions — again, very similar.

    Two View Overlay

    Another question repeatedly asked is why we don’t include the “Buffett Indicator” in the overlay of thefour valuation indicators updated monthly. We’ve not included it for various reasons: The timeframe is so much shorter, the overlapping timeframe tells the same story, and the four-version overlay is about as visually “busy” as we’re comfortable graphing.

    One final comment: While this indicator is a general gauge of market valuation, it it’s not useful for short-term market timing, as this overlay with the S&P 500 makes clear.

    Two View Overlay

    Images: Flickr (licence attribution)

    About The Author

    My original dshort.com website was launched in February 2005 using a domain name based on my real name, Doug Short. I’m a formerly retired first wave boomer with a Ph.D. in English from Duke. Now my website has been acquired byAdvisor Perspectives, where I have been appointed the Vice President of Research.

    My first career was a faculty position at North Carolina State University, where I achieved the rank of Full Professor in 1983. During the early ’80s I got hooked on academic uses of microcomputers for research and instruction. In 1983, I co-directed the Sixth International Conference on Computers and the Humanities. An IBM executive who attended the conference made me a job offer I couldn’t refuse.

    Thus began my new career as a Higher Education Consultant for IBM — an ambassador for Information Technology to major universities around the country. After 12 years with Big Blue, I grew tired of the constant travel and left for a series of IT management positions in the Research Triangle area of North Carolina. I concluded my IT career managing the group responsible for email and research databases at GlaxoSmithKline until my retirement in 2006.

    Contrary to what many visitors assume based on my last name, I’m not a bearish short seller. It’s true that some of my content has been a bit pessimistic in recent years. But I believe this is a result of economic realities and not a personal bias. For the record, my efforts to educate others about bear markets date from November 2007, as this Motley Fool article attests.
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