The Buffett indicator – Everything you need to know

The Buffett indicator is “probably the best single measure of where valuations stand at any given moment” – This is a quote by no other than the legendary Warren Buffett.

The goal of this post is to explain what this indicator is, how it is being calculated, the logic behind it as well as the challenges that come with it.

Let's get started!

What is the Buffett indicator?

In one sentence, it is a simple ratio between the market cap of the public companies within a certain country and the GDP of the same country. So, what does this ratio tell us, how should one read it?

To best understand the logic behind it, let's go to the extremes and imagine that there's a country with the following assumptions

1. All companies are public.
2. The country is isolated (does not trade with any other country)

If this is the case, the market cap would represent how much one should pay to buy ALL of the companies that are out there. These companies are also responsible for the output of the goods and services that are measured through the GDP.

Over a long period of time, this ratio would give us an idea of whether the stock market is expensive or cheap, which is the purpose of this indicator.

Of course, in reality, these assumptions aren't true.

For the US, the Buffett indicator is being measured by taking the Wilshire 5000 (a market-cap-weighted index of the market value of American stocks traded in the US) as it includes a majority of the common stocks and REITs and it is being compared against the US GDP.

Back in the 1950s, a normal ratio (where the stock market is fairly valued) was around 45%. Today, 70 years later, a normal ratio is considered around 120%. (Note, the % mentioned are only applicable to the US)

So, why is this ratio increasing over time? There are 3 arguments to touch upon:

1. There are more public companies over time – This is the weakest argument as there are also companies that are being de-listed for various reasons)
2. International sales impact market value, not GDP – This is a strong argument. Numerous companies create value outside of the US and that is captured in their market cap. However, this isn't captured in the GDP of the US.
3. Technological advances combined with increased productivity increase profits – This is also a strong argument. If a company manufactures chairs and discovers a new more efficient and effective ways to make the same chair, well, the output is the same, so there won't be any change when it comes to the GDP. However, the margins will increase, which means higher profits, and that of course leads to a higher market cap.

Can the indicator be used for countries other than the US?

The indicator can be calculated for almost all countries, but there are a lot of things to keep in mind.

1. It requires obtaining data for a fairly long period of time. A decade isn't enough if the stocks are expensive or cheap throughout the entire decade.
2. There's no % as a benchmark that can be used to assess whether the stock market is expensive or cheap. This is an indicator that provides insights once it is compared to itself at a different point in time.
3. Events that have significant value should be identified. These are rare, but there's an example of Aramco, one of the largest public companies, which became a public company a few years ago. Of course, this had no impact on the GDP of Saudi Arabia, but it added 7 trillion Saudi Riyal (around $2 trillion) to the market cap.
4. If public companies contribute a fairly low % of the GDP, the indicator is almost useless

How useful is the indicator?

In the past, it is quite clear that the indicator can remain around 1 standard deviation (above and below) for an extended period of time. However, on only two occasions did it reach the height of 2 standard deviations in this millennium. Once, during the dot-com bubble and the second time at the last peak in 2020/2021. In both cases, there was a correction fairly soon.

This might be another tool in the arsenal for the individual investor to assess where the market is.

The criticism

However, in my opinion, this indicator should be used in combination with other relevant financial data. The indicator is rightfully criticized for ignoring the interest rate. Of course, this has a significant impact on the valuation of the companies. Although there were 2 occasions where the indicator showed the market was significantly overvalued, in the first case (with the dot com bubble), the 10-year Treasury rate was over 6%. In the second case, it was closer to 1%.