Using The Buffett Indicator To Value Stocks| MENAFN.COM

Wednesday, 10 August 2022 08:28 GMT

Using The Buffett Indicator To Value Stocks


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Warren Buffett , one of the most well-known and successful investors of all time, approaches the market as a value investor. That's why he created the Buffett indicator, which uses the ratio of the total U.S. stock market relative to the nation's GDP to determine how expensive or cheap the aggregate market is right now. In using this metric, we can understand whether the market is underpriced or overpriced as a whole. Thus, it can help us better understand the state of the economy. If you're wanting to find more ways to know when to invest, consider working with a financial advisor.

Table of Contents show
  • 1. What Is The Buffett Indicator?
  • 2. How To Calculate The Buffett Indicator
  • 3. What The Buffett Indicator Tells Us
  • 4. Bottom Line
    • 4.1. Tips for Investing
What Is The Buffett Indicator?

The Buffett indicator is a metric we can calculate by dividing the total value of the stock market by the country's GDP . To arrive at this number, the common approach is to divide the total value of the Wilshire 5000 Total Market Index by the total U.S. GDP.

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The Wilshire 5000 is named for the roughly 5,000 companies the index contained when it launched in 1980. Since then, the number of companies has fluctuated, but the name has stayed the same. GDP figures are released quarterly by the Bureau of Economic Analysis (BEA). As of this writing, the most recent data available is for first quarter 2022.

Buffett first proposed the metric in a 2001 piece in Fortune Magazine. At the time, he suggested looking back 80 years in time, stating that it is the single best measure of where valuations stand at any given time. In the context of the dot-com bubble , he pointed to the fact that valuations rose sharply using the metric, which should have been a warning sign, he said.

In the original piece, Buffett suggested that buying stocks is a very good idea when the indicator falls to between 70% and 80%. Conversely, buying stocks when the ratio approaches 200% is a recipe for disaster. Notably, the ratio has surpassed 200% one time since 2001, during the COVID-19 economic recovery .

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How To Calculate The Buffett Indicator

As of March 31, 2022, the adjusted market capitalization of the entire stock market was $41.35 trillion. Meanwhile, in the first quarter U.S. GDP was $24.38 trillion, according to the BEA's most recent data.

Using these numbers for our calculation, the Buffett indicator for first quarter 2022 is about 170%. This means the aggregate value of the U.S. stock market is nearly double the country's total GDP. However, the stock market has been down in 2022; it surpassed 200% briefly at the end of 2021.

This metric can be calculated as far back as 1970, and from that time until nearly the new millennium, the Buffett indicator was below 100%. It first crossed the 100% threshold with the dot-com bubble, then again in the years-long bull market following the Great Recession . In fact, it hasn't been below 100% since 2013.

What The Buffett Indicator Tells Us

The Buffett indicator is a quick and easy calculation. The general idea is that if the aggregate value of the market surpasses the country's entire GDP, then it is overpriced. However, the simplicity of this metric means it is somewhat limited in its usefulness.

For one, as mentioned, the Buffet indicator has not been below 100% since 2013. Even in March 2020, when the market experienced a rapid drop, the Buffett indicator was slightly above 100%.

The Buffett indicator also does not tell us much about individual companies or even indices such as the S&P 500 . It suffices to say that there were companies that were overvalued while the Buffet indicator was below 100%, and there are companies that are undervalued now that it is above 100%.

However, some analyses do suggest that the Buffet indicator may have a predictive indicator. The most recent example is indeed in early 2020 when it dropped from nearly 160% in January to 110% by March. That drop was followed by a sharp increase and those who invested heavily in March 2020 saw big gains through April and May.

Still, we can see similar drops followed by sharp increases in the S&P 500, Dow Jones , etc. Perhaps one insight from the Buffett indicator, then, is that GDP tends to move in the same direction as the aggregate market.

Bottom Line

The Buffett indicator is a simple metric that attempts to show whether the stock market is currently undervalued , fairly valued or overvalued . A value of 100% would indicate a fair value, while a Buffett indicator between 70% and 80% would show a strong buying opportunity. Thus, a Buffett indicator over 100% means the market is overvalued and it isn't the best time to buy. While the indicator can provide signs of when to invest, it's still a good idea to first consult with a financial advisor.

Tips for Investing
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  • Unsure how much your investments will grow over time? Try SmartAsset's free investment calculator to estimate how much you will have in 10, 15 or 20 years. Whatever your time horizon might be, it's important to know where you stand. If you want to see where you stand, use our free calculator .

Updated on Jul 5, 2022, 1:51 pm

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