Tune Out The Buffett Indicator

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Includes: DIA, IWM, QQQ, SPY
by: Joseph Meth

Summary

Long-term measures like Buffett Indicator aren't market timing tools.

You would have been out of the stock market since 1998 if you followed the Buffett Indicator.

Market momentum is linked to Fed policies.

Warren Buffett continues to state in interviews that he can't find any fairly valued companies to add to his Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) portfolio and backs up this claim with the current value of his "Buffett Indicator". The Indicator is calculated as a ratio with the total value of America's public businesses (i.e., publicly owned stocks, bonds, etc.) as the numerator and the measure of total economic activity (i.e., GDP) as the denominator. However, like the Shiller P/E ratio and other extremely long-term measures, the Buffett Indicator may indicate when stock values are "overvalued" by historic standards, but it is not a great market timing tool that indicates when stocks should be bought or sold.

As the following chart from dshort.com shows, the Buffett Indicator reading has exceeded levels defined as a "normal bull ratio" ever since 1995, except for brief periods at the troughs of the two Secular Bear Market crashes in 2003 and 2009 when the market bottomed very close to what the indicator measure considers "normal bull peak" ratios. Even at those severe depths of the market collapses, the indicator hadn't even approached what in 1953 and 1982 were considered a "ratio prior to major bull market" levels. If we had waited to buy stock until the ratio declined to those "normal" low levels, we would have been out of the market for the past 17 years since 1998.

Buffett Indicator

Obviously, the best time to buy stocks is when businesses are cheap relative to economic activity (as measured by the GDP) like in 1952, 1981 and 2009. Conversely, the worst time to put new money at risk in stocks is when valuations are high like 1969, 1972 (labeled a "normal bull market peak" ratio), 1999 (labeled "outbreak of utter insanity") and... currently?

If determining market timing were as easy as calculating "ratio prior to major bull markets" then prices wouldn't fluctuate since no one would buy stocks when they became "overvalued"... but they do. Something else must be dictating prices. If measures like the Buffett Indicator aren't successful in identifying market tops and bottoms, then what tools do? The answer is that valuations are based more on momentum and for right now, there doesn't seem to be any erosion in market momentum.

The market is clearly being levitated by the Fed at levels which are considered overvalued in historical terms. Low interest rates around the world makes the US dollar and stock market seem attractive stores of value. This condition should continue until the Fed aggressively reverses its policy of supporting the economy.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.