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In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that

"The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment".

He further went on to say,

"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire".

Such a simple yet elegant metric (we call it the Buffett Stock Market Indicator) could be implemented in several ways. At the moment, ValidFi maintains a strategy called Warren Buffett Total Stock Market Value to GNP Ratio Strategy. This strategy characterizes the stock market valuation into the following five categories:

  • Significantly Overvalued (SO): such as if the ratio >= 115%.
  • Modestly Overvalued (MO): such as if 90% <= ratio < 115%.
  • Fairly Valued (FV): such as if 75% <= ratio < 90%.
  • Modestly Undervalued (MU): such as if 50% <= ratio < 75%.
  • Significantly Undervalued (SU): such as if ratio < 50%

These five categories are determined by four valuation parameters (such as 115%, 90%, 75% and 50% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what category the US stock market valuation is and then does the following rebalancing:

  • SO: 0% in stock, 100% in cash.
  • MO: 25% in stock, 75% in cash.
  • FV: 50% in stock, 50% in cash.
  • MU: 75% in stock, 25% in cash.
  • SU: 100% in stock, 0% in cash.

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users (using TMW or VTI). Users could adjust the valuation parameters to get an effect such as only buying at significantly undervalued level and selling at significantly overvalued level. Some of model portfolios of this strategy are:

  • SO: >=115%, MO: [90%, 115%), FV: [75%, 90%), MU: [50%, 75%), SU: <50%.
  • SO: >=115%, MO, FV, MU: [50%, 115%), SU: <50%.

The total US stock market valuation is based on Wilshire 5000 index while the GNP is based on Federal Reserve's quarterly released number. From 12/31/1980 to 9/18/2009, the weekly adjusted portfolio achieves 8.648% annualized return and standard deviation 12.2% compared with Wilshire 5000 total return's annualized return 7.4% and standard deviation 17.5%.

It is even more amazing if an investor opted to invest only when the market was significantly undervalued and went to cash when the market became significantly overvalued. Such a strategy would keep an investor in cash from 2/27/1998 to 3/6/2009: avoiding the last two bubbles altogether! The following figure shows the transactions:

image

Such a portfolio achieves annualized return 9.71% with standard deviation 11.4% from 12/31/1980 to 9/18/2009. There are only 3 transactions during this whole 29+ year period.

On last Friday (9/18/2009), the Buffett Indicator stood at 77.5%, valuing the US stock market as Fairly Valued if one uses the 5 categories above.

Disclosure: No Positions

Source: Buffett Valuation/GNP Indicator: This Market's Fairly Valued