Today I am going to make a somewhat nuanced argument about the dangers of indicators and metrics for valuing stocks.
Let’s use arguably the greatest investor of all time, Warren Buffett, and what he describes as, “probably the best single measure of where valuations stand at any given moment.” Buffett's favorite metric compares the total price of all publicly traded companies to gross domestic product. This metric can also be thought of as a way to judge the valuations for all U.S. companies relative to the total amount of U.S. economic activity. According to Buffett, when the resulting figure is above 100 percent, stocks are overvalued.
A Google search for “Warren Buffett's favorite indicator” will return several million hits and you can find dozens of articles citing the indicator -- it is most often used to prove that stocks are pricey.
The reality of its meaning is much more complex.
Ron Griess, who runs the Chart Store, has been looking at charts for more than 40 years. He makes the observation: “There are no bad indicators. There ARE bad interpretations of indicators. I place the Market Cap/GDP indicator in the class of indicators that is often interpreted poorly.”
Why is that?
Knowing if something has a higher or lower value compared to its historic mean doesn't provide much insight as to whether you should buy or sell it. Indeed, stocks can become, and stay, oversold or overbought for long periods of time. As some bulls will tell you, a persistently overbought stock is a sign of strength.
So what does market cap as a percentage of GDP tell us? The answer is: Much less than it used to.
Valuation relative to U.S. GDP assumes that the U.S. economy is the driver of capitalization. It really isn’t. Numerous studies have found very little correlation between current economic activity and the stock market.
Then there is globalization. The percentage of income that the S&P 500 derives from overseas activity is now about 50 percent, up significantly from where it was about 20 years ago -- in the 30 percent range. Given that half of SPX earnings are coming from overseas, comparing market cap to U.S. economic activity paints only a partial picture.
Finally, we have to consider the historical track record. This past weekend, Griess noted an interesting anomaly about this indicator to his subscribers. From the time Alan Greenspan first used the infamous phrase “irrational exuberance” in late 1996, stocks have almost always, by this measure, been overvalued. Since October 1996, this ratio has been measured as overvalued (above 100 percent) for all but 17 months (out of 208). That means, according to Buffett’s favorite metric, stocks in the U.S. have been overvalued 92 percent of the time since 1996.
Griess notes that “in a broad sense, it does provide some indication of stock market valuation. However, indicators go overvalued/overbought or undervalued/oversold and stay there for much longer time periods than one would think they could.” In the case of Buffett’s favorite indicator, however, that renders it more or less useless to the average investor.
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