«The percentage of total market capitalisation relative to GDP is probably the best single measure of where valuations are at any given time.» – Warren Buffet
All the analysis in this article is based on this ratio:
Buffett Indicator = Total Market Capitalisation / GDP.
It is like the Price-to-sale ratio (Share Price / (Total Revenue / Number of Shares). But in this case, the price is the total market capitalisation of all shares traded, and the sales are the total gross national product of the country.
To understand the underlying logic of the Buffett Indicator (ratio of total market capitalisation (TMC) to GNP), we need to understand the business cycle.
Therefore, we will try to explain the business cycle.
Interest Rates and Market Valuation
«Interest rates act on financial valuations as gravity acts on matter.» – Warren Buffet
In other words, the higher the interest rate, the greater the downward pull. Why? Because the rates of return investors need from any kind of investment are directly linked to the risk-free rate they can get from government securities. Therefore, if the government interest rate rises, the prices of all other investments must adjust downwards, to a level that matches their expected rates of return. Conversely, if government interest rates fall, the prices of all other investments rise.
During recessions, corporate profit margins shrink, and during periods of economic growth, corporate profit margins widen. However, long-term growth in corporate profitability is close to long-term economic growth (which is why long-term investments are safer).
Therefore, if we have a higher stock market valuation, it is because it is correlated with lower long-term profitability in the future. On the other hand, a lower current valuation level correlates with higher long-term returns. Whatever the scenario, the total market valuation always returns to its mean.
Business Growth and Dividends
The value of any business is determined by the amount of money it can generate. That is, the growth in the value of the business comes from the growth in profits, which is reflected in the appreciation of the company’s share price.
If we look at the economy in general, the growth in the value of the entire stock market comes from the growth in corporate profits.
Dividends are an important part of investment returns. They come from a company’s cash income (they are a % allocated for dividends out of Free Cash-Flow). When the Profit for the Year, the Accumulated Negative Profit for the Previous Years and the Cash-Flow for dividends are positive (+), the company distributes the minimum between the Profit for the Year and the Free Cash-Flow for dividends.
This translates into a lower growth rate for the company when there is a higher dividend payout ratio. Therefore, if a company pays out dividends while continuing to grow profits, the dividend is an additional return to shareholders in addition to the appreciation in the value of the business.
GDP, GNP and Total Market Capitalisation
The market capitalisation of a company is the total value of the shares. We basically measure the size of that company in the economy. And when we refer to total market capitalisation, we are talking about the amount of shares and therefore money in the market. In this case in the US economy.
- Gross Domestic Product (GDP) is «the total market value of goods and services produced within a country’s borders».
- Gross National Product (GNP) is «the total market value of goods and services produced by a country’s residents, even if they live abroad».
For example: if a resident of the United States earns money from an investment abroad, that value would be included in GNP (but not in GDP).
Therefore, the size of the US economy is measured by Gross National Product (GNP).
The US economy, like any economy, is driven primarily by consumption and individuals who must produce in order to consume. With this cycle, companies generate revenues and profits, resulting in a profitability that is ultimately reflected in the stock market. GDP, which reflects the total value of production, is thus an underlying driving force of corporate profits as well as total market capitalisation.
What is the problem?
As of today, the total market index stands at $42,099.9 trillion, which is about 196% of the last recorded GDP. The US stock market is positioned for an average annual return of -3.1%, estimated from historical stock market valuations. This includes dividend yields, which are currently 1.48%.
Furthermore, many people will say, «you are not taking into account the Federal Reserve’s Total Assets», a factor that can be quite influential on market capitalisation. The Fed buys assets when it wants to increase the money supply and sells assets when it wants to reduce the money supply. This has a direct connection to the interest rates we discussed earlier. If the Fed’s objective is expansionary, it pours more money into the market and lowers the interest rate. In this case, money can be borrowed at a lower rate, which encourages individuals to consume and companies to expand their businesses. On the other hand, a huge fall in interest rates also promotes investment, as it makes a dollar of future profit much more valuable.
This is one of the reasons why the Federal Reserve’s balance sheet has been used for decades to predict changes in economic cycles. The expansion and contraction of the balance sheet can certainly influence the economy and the consumption of individuals and businesses.
Federal Reserve in the Buffet Indicator
We add the total assets of the Federal Reserve Banks together with GDP. As of today, the Total Market Index is approximately 145.8% of the sum of the last reported GDP and the Total Assets of the Federal Reserve. The US stock market is positioned for an average annual return of -1.4%.
This means that the stock market is OVERVALUED.
- Based on the historical ratio of total market capitalisation to GDP (currently at 196%), the return is likely to be -3.1% including dividends.
- Based on the historical ratio of total market capitalisation to GDP plus total assets of Federal Reserve Banks (currently at 145.7%), a return of -1.4% including dividends is likely.
Conclusion
In someway, this is totally illogical in every way. There is a decorrelation between investors’ expectations and the country’s economic growth. It is true, that in 2017 and 2018, a ratio above 100% was also maintained, with 80% < ratio > 90% being the most consistent result. But this time it is too high and the circumstances are not the same….
The Coronavirus health crisis has caused the biggest economic meltdown in US history. The unprecedented fall in GDP has triggered market capitalisation relative to the growth of the economy. Aggregate demand is being suppressed, but much more has yet to be suppressed. Unemployment is at record highs, thousands of companies are disappearing and yet US equity capitalisation is over 100% of GDP… The market is overvalued!
US economy could be a bubble and could burst at any moment to return to its average (possibly end 2021, early 2022), plummeting completely and leaving us with the worst financial crisis in history (with Banks, Investment Funds and large companies being the most affected). The biggest fear, though, is the possible domino effect it could create again in the world economy.
Return on investment (%) = Dividend yield (%) + Business growth (%) + Valuation change (%)
Valuation change: (Re/Rb)(1/T)-1
Rb = Initial ratio
Re = Final ratio
T = Initial and final market ratios for the period of time under consideration
Return on investment (%) = Dividend yield (%) + Business growth (%) + (Re/Rb)(1/T)-1
From this equation we calculate the likely returns that an investment in the stock market will generate over a given period of time.