The Warren Buffett Indicator Is Now Telling You Not To Bet On America

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Includes: DIA, GXC, QQQ, RSX, SCHE, SPY
by: Steven Chen

Summary

Market-Cap-to-GDP is Warren Buffett's all-time favorite valuation indicator.

Here is a recap on where each country stands in terms of valuation based on the Buffett Indicator.

Actionable recommendations are provided to capture value.

Background

Warren Buffett, Chairman & CEO of Berkshire Hathaway (BRK.A) (NYSE:BRK.B), is famous for his value investing philosophy - i.e., buying wonderful businesses at fair prices. In terms of judging the price fairness of a broad stock market, Buffett turns to this Market-Cap-to-GDP ratio (so-called the Buffett Indicator), which he often claimed is "probably the best single measure of where valuations stand at any given moment."

The ratio argues that the total combined value of a country's stocks should be worth to some degree relative to the Gross Domestic Product of that country's economy. The higher the Buffett Indicator, the more expensive the stock market is compared to its GDP, and therefore, the lower the expected return could be for the future.

Global Valuations

Let's take the United States for an example -

  • Total market cap: USD 29.1 trillion
  • Total GDP: USD 19.5 trillion
  • The Buffett Indicator (vs. historical mean): 149% (vs. 75%)

Historical Market-Cap-to-GDP of the US Stock Market

Source: GuruFocus; Data as of 1/17/2018.

Per the chart above, the Buffett Indicator has varied within a very wide range. The lowest point was about 35% in the deep recession of 1982 while the Indicator hit a recent low at around 60% during the financial crisis before bouncing back significantly over the long bull market. The reading of the ratio as of market close on 1/17/2018 is an astonishing 149%, hitting its all-time high, just past the previous highest point of 148% achieved during the tech bubble in 2000. According to the Warren Buffett Indicator alone, we are seeing the biggest stock market bubble in the recent American history.

Compared to the ratio's historical average of 75% in the States, the broad stock market is overvalued with almost 100% premium at this level.

We now apply the same methodology to value major stock markets and notice (see the table below) that among all major stock markets, the US market is the most overvalued, followed by Germany (67% premium) and Japan (24% premium). Stocks in the UK (6.8% premium), Canada (4.2% premium), and France (5.7% premium) are slightly overpriced, while Australia (22% discount) and Italy (4.2% discount) are the only undervalued stock markets in the developed world here. All the BRIC markets are in the undervalued territory, with China (68% discount) and Russia (60% discount) being the cheapest, followed by India (14% discount) and Brazil (11% discount).

The Buffett Indicators of Major Economies

Current Level Historical Mean Valuation (compared to historical avg.)
The United States 149% 75% Overvalued with 99% premium
China 47% 148% Undervalued with 68% discount
Japan 172% 139% Overvalued with 24% premium
The UK 126% 118% Overvalued with 6.8% premium
Germany 55% 33% Overvalued with 67% premium
India 65% 76% Undervalued with 14% discount
Canada 124% 119% Overvalued with 4.2% premium
Australia 110% 141% Undervalued with 22% discount
Russia 24% 60% Undervalued with 60% discount
Brazil 47% 53% Undervalued with 11% discount
France 92% 87% Overvalued with 5.7% premium
Italy 15% 21% Undervalued with 4.3% discount

Source: GuruFocus; Data as of 1/17/2018.

Apparently, the Buffett Indicator suggests that long-only investors should buy into China, Russia, Australia (and maybe Brazil and India) while staying away from at least the US, Japan, and Germany. For those investors who would like to be more diversified to eliminate single-country concentration risks, below is the valuation analysis from a broader geographic perspective.

The Buffett Indicators across Major Equity Asset Classes

Current Level Historical Mean Valuation (compared to historical avg.)
The U.S. 149% 75% Overvalued with 99% premium
Ex-US Developed 104% 93% Overvalued with 12% premium
Emerging Markets (BRIC) 48% 120% Undervalued with 60% discount
Total World 101% 96% Overvalued with 5.7% premium

Data as of 1/17/2018.

The calculation tells us that the Emerging Markets equities look quite attractive, compared to the very expensive US equities. Stocks in Ex-US developed countries are overvalued as a whole asset class, and so is the total world stock market at this point.

What Could Go Wrong?

The Buffett Indicator is easy to use and makes logical sense in terms of valuing the overall stock market. However, there are some shortcomings that we may want to be aware of:

  1. The Buffett Indicator is more like a Price-to-Sales ratio for the entire country. However, the quality of that "Sales" varies in different economies - e.g., profitability on the sales, capital efficiency to generate the sales, free cash flow from the sales - all these factors may evolve over time. For example, some would argue that Corporate America nowadays earns higher profitability, is run more efficiently, generates stronger free cash flow, and is more friendly in terms of rewarding its owners, therefore deserving a richer valuation than before and other countries.
  2. The formula does not take the GDP growth rate into consideration. High-growth countries deserve high ratios (of course, this would make the Emerging Markets look even more attractive).
  3. Even if we would like to price in the growth rate, the GDP growth could mean differently to equity investors in different types of economies. For countries like the US, advancement in technologies contributes significantly to the GDP growth. Hence, businesses are run more than more efficiently, generating higher ROE/ROIC and potentially enhancing returns for shareholders. For others like China, the economic growth is more driven by capital investments - quite often at low ROIC/ROE into capital-intense projects, such as real estates and infrastructures. Such economic developments probably would not produce high returns for equity holders.

Conclusion

The Buffett Indicator is a useful tool to gauge where the overall stock market stands in terms of valuation. The current reading urges investors to stay away from the US stock market, implying stocks are in a bubble even bigger than any previous ones including the Dot Com Bubble. I certainly would not suggest betting against America by shorting the market, but be fearful when others are greedy betting on America these days.

In the meantime, the reading also indicates great value in the Emerging Markets, particularly China and Russia. Investors can get exposures through ETFs with reasonable expense ratios - e.g., SPDR S&P China ETF (GXC) at current portfolio P/E of 11.35x, Market Vectors Russia ETF (RSX) at current portfolio P/E of 7.04x. Those who would like a broader and more diversified bet on the region can consider Schwab Emerging Markets Equity ETF (SCHE) at current portfolio P/E of 12.91x.

Disclosure: I am/we are long SCHE, BRK.B.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.