Warren Buffett's Stock Market Valuation Metric

Jan. 28, 2013 9:19 AM ETIWM, SPY
Jaimini Desai profile picture
Jaimini Desai

In the opening chapters of Alice Schroeder's "The Snowball," she recounts Warren Buffett's Sun Valley speech in 1999. The gist of Buffett's speech was to express his belief that tech stocks were going to cause a lot of pain. With the benefit of hindsight, his speech is a revelation in its accuracy. And like anything from Buffett, there are some great lessons to learn.

I will be talking about pricing stocks, but I will not be talking about predicting their course of action next month or next year. Valuing is not the same as predicting. In the short run, the market is a voting machine. In the long run, it's a weighing machine. Weight counts eventually. But votes count in the short term. And it's a very undemocratic way of voting. Unfortunately, they have no literacy tests in terms of voting qualifications, as you've all learned. - W.B. Sun Valley Conference, 1999

He goes on to compare the 1990s bull market with its lagging profits and rising prices due to multiple expansion to the 17-year period between 1964 and 1981, when GNP and revenue of Fortune 500 companies grew fivefold.

Below is a chart of P/E ratios over the history of the S&P 500. The multiple compression from 1964-1981 is quite clear as well as the multiple expansion in the late 90s. And, we see that today multiples are back within the confines of the historical range.

One way to use P/E ratios is as a measure of investor optimism about the future. In the early 1980s, there was little excitement surrounding the stock market with Businessweek's infamous "Death of Equities" cover. The peak of a bull market coincides with incredible optimism and unrealistic expectations of the future while the bear market ends with total disinterest in the stock market.

This article was written by

Jaimini Desai profile picture
I am an independent trader. I began actively trading in 2008 and my perspective is shaped by the collapse of 2008 and the incredible rally of 2009. My approach consists of seeking out fundamentally strong stocks that are unloved by the market and then assessing general market conditions to manage risk. Outside of the markets, I enjoy playing tennis, working out, and pushing myself to conquer my fear of public speaking.

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