Is the Buffett indicator indicating that the markets are headed for a crash?

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“The Buffett Index He says the stock market will crash. This was an email I received recently that deserves a more detailed discussion. Let me start with my favorite font from “The Princess Bride.”

“I’m not I think it means what you think it means.”

The Buffett Index is a rating scale that compares stock market capitalization to gross domestic product. Warren Buffett’s favorite, Pointer Shy 2.44 times the market value of GDP. This number doesn’t mean much on its own, but it is striking when placed in a historical context. Even after the recent dip in the markets, the ratio is still one of the highest ever, north of the 2.11 level recorded during the dotcom bubble in 2000significantly higher than the average since 1950.

Inflation-adjusted market value/GDP ratio

Since 2009, frequent monetary interventions and zero interest rate policies have led many investors to reject any action “evaluation.” The reason is that since there is no direct correlation, the pointer is false.

The problem is that evaluation models are not and weren’t supposed to be, Market timing indicators. ” The vast majority of analysts assume that if there is a rating scale (P/E, P/S, P/B, etc.) reaches a certain level, it means that:

  1. The market is about to crash,
  2. Investors must be 100% in cash.

this is not true. Rating scales are just a measure of the current rating. More importantly, when ratings are excessive, it is a better measure “Investor Psychology” And the appearance of The Great Fool Theory.

What valuations provide is a reasonable estimate of long-term investment returns. It stands to reason that if you overpay for a stream of future cash flows today, your future return will be low.

Why is the Buffett Index valuable?

While often overlooked, the Buffett Index tells us as much as it measures “Market value” to me “Gross domestic product”. To understand the relative importance of scale, we must understand the economic cycle.

Buffett Index

The premise is that in an economy driven by approximately 70% consumption, individuals must produce to earn salaries for consumption. This depreciation is where businesses derive their revenue, and ultimately profits. If something happens that results in less production, the entire cycle reverses, resulting in an economic downturn.

The example is simplified, as many factors affect the economy and markets in the short term. However, economic growth and corporate profits have a long-standing historical relationship. Therefore, while it is possible for profits to grow faster than the economy at times, that is, after a recession, they cannot outrun the economy indefinitely.

annual growth

Since 1947, earnings per share have grown 7.72% annually, while the economy has expanded by 6.35% annually. Again, the close relationship in growth rates must make sense. This is particularly the case given the important role of spending in the GDP equation.

Therefore, the Buffett Index tells us that overvaluation is not sustainable when the market value of stocks grows faster than economic growth can support. Therefore, the market capitalization ratio (the price investors are willing to pay multiplied by the total number of shares outstanding) Greater than 1.0 is overvalued, and less than 1.0 is undervalued. Today, investors pay 2.5 times what the economy can generate in revenue and profits.

Does this overvaluation mean the stock market is going to crash? number.

However, there are important implications that investors should take into account.

valuations and forward returns

As always, while the reviews are awesome Market timing They are an excellent indicator of future returns. I previously quoted Cliff Essence On this issue in particular:

“Average ten years forward Yields fall almost monotonously as the Shiller P/E starts to increase. Also, as the Shiller P/E kicks in, the condition gets worse and the better ones weaken.

If today’s Shiller P/E is 22.2, and your long-term plan requires a nominal return of 10% (or with today’s real 7-8% inflation) in the stock market, You’re basically rooting for the absolute best state in history to play again, and you’re rooting for something significantly above the average state of these ratings.”

We can prove this by looking at 10-year total returns against different levels of P/E ratios historically.

10 year forward real returns

Asness continues:

“He. She [Shiller’s CAPE] It has very limited use of market timing (Definitely on their own) And there is still considerable variance about his predictions over the decades. But, if you don’t lower your expectations when your Shiller P/E earnings are high for no good reason And, in my opinion, the critics did not give a good reason this time. I think you’re making a mistake.”

And as we’re discussing Mr. Buffett, let me remind you of one of Warren’s most insightful quotes:

“Price is what you pay, value is what you get.”

The Buffett Index Emphasizes Mr. Essence’s point. The chart below uses Wilshire 5000 market capitalization versus GDP and is calculated based on quarterly data.

Buffett's 10-Year Return Index

Not surprisingly, like any other rating scale, expectations of future returns will be much lower over the next ten years than in the past.

The basics don’t matter until you do

In the “The heat of the moment,” The basics don’t matter. As mentioned, they are bad timing indicators.

In the market where the momentum leads the participants because of “Fear of Missing (FOMO),” The basics are replaced by emotional prejudices. This is the nature of market cycles and one of the essential ingredients needed to create the right environment for an eventual comeback.

Note, I said at the end.

As David Einhorn once stated:

Bulls make it clear that traditional valuation metrics are no longer valid for some stocks. Longs are confident that everyone else who owns these stocks understands the dynamic and won’t sell either. With the reluctance of stockholders to sell them It can only rise – seemingly to infinity and beyond. I’ve seen this before.

there It was not a trigger that we know of about the dotcom bubble bursting in March 2000, and we don’t have a specific trigger in mind here. However, the summit will be the summit, and it is difficult to predict when it will happen.”

Furthermore, as James Montier previously stated:

The current arguments as to why the difference this time around are hidden in the secular recession economics and standard business of finance such as the equity risk premium model. While these may lend an illusion of respectability to those dangerous words, dealing with prima facie arguments without looking at the evidence seems to me, at least, a common link with earlier bubbles.

Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, yield expectations for the next 10 years are likely to be as negative as they were in the 10 years after the late 1990s.

It is good for investors to remember the words of then-Securities and Exchange Commission Chairman Arthur Levitt. In a 1998 letter entitled The numbers gameHe said:

“While the temptations are great, and the pressures are strong, illusions in numbers are just that—ephemeral, and ultimately self-destructive.”

Regardless, there is a straightforward fact.

“The stock market is not the economy. But the economy is a reflection of the very thing that underpins rising asset prices: profits.”

No, the Buffett indicator does not mean that the markets will definitely crash. However, there are more than reasonable expectations of disappointment in future market returns.

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Editor’s note: This article’s bullet point summary was selected by searching for alpha editors.

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