Buffett's 'Bubble Red' Indicator

by: Calafia Beach Pundit

You may have noticed a recent post on Zero Hedge ("Forget Shiller's CAPE, Warren Buffett's 'Best Indicator' Is Flashing Bubble Red"). It includes a chart that shows the market value of U.S. companies as a % of nominal GDP, and it does look scary: by this measure equity valuation is almost as extreme as it was in early 2000.

I can't vouch for the data behind the ZH graph, but I can vouch for the data used to create the above graph. In my experience, the S&P 500 index has been the best measure of the performance of the U.S. stock market, and it has also been the best proxy for the value of U.S. corporations. What I think this graph shows is that the ratio of company valuations to GDP is not yet extreme, being approximately equal today to what it was in the early 1960s when inflation was low and stable and U.S. interest rates were low and stable, much as they are today.

If I had to guess, I would say that over the next several years nominal GDP growth will pick up (it was a meager 1% or so in the first half of this year), while the growth of equity prices will slow down. Both of those developments would be consistent with higher bond yields and a leveling off of the equity/nominal GDP ratio. In other words, we're not necessarily in an equity bubble, and an equity bubble is not necessarily inevitable.