Buffett’s Favorite Valuation Indicator Is Wrong

We try not to argue with investors that are far richer than us. After all, they have the personal balance sheets to prove their approach is superior to ours. But even the best minds in the game sometimes get things wrong.

Today’s example: a metric often called “Warren Buffett’s favorite market valuation indicator”. The measure is simple: a ratio of a country’s aggregate stock market valuation to its GDP. The math translates (loosely) to the following buy/sell signals:

• Numbers below 50% are “Cheap”.
• Anything over 100% gets to be “expensive”.
• Those ranges are based on long-term historical readings, most commonly calculated back to the early 1970s.

Based on those numbers, US equities are very expensive indeed. Domestic GDP is $20.4 trillion. The market cap of the Wilshire 5000 at the end of June 2018 was $24 trillion (115% of GDP), and $30 trillion (147%) if you include shares locked up by founders/other holders that aren’t available to trade. Neither number looks good.

At the same time, market cap/GDP misses a lot of fundamental inputs that clearly have a role in setting stock prices. For example:

#1: Interest Rates. Equity markets discount expected future earnings by a discount rate anchored on long term Treasuries. Market cap/GDP ignores this, assuming long-term rates will revert to some historical average.

From 1970 to today that average would be 7%, but current yields are 3% and those naturally push equity valuations higher. So yes, if you think 10-Year Treasuries will soon yield 7%, by all means avoid US stocks with our blessing. That seems unlikely, however, and if they do we likely have far larger problems than stock prices.

#2: Globalization. As US companies increase their international footprints and profits, domestic GDP is a less valuable point of comparison for stock valuations. Right now, fully 38% of S&P 500 revenues come from non-US sources. In the 1990s, that number was 20%. Credit the Technology sector for much of that shift, where 58% of sales come from outside the US.

#3: Changes in Corporate Taxes. From the 1950s to the early 1980s, corporate taxes hovered around 50% (albeit with plenty of loopholes for companies large enough to exploit them). Now, of course, they are 21%. That drives higher margins and loftier valuations since returns on capital are better. But GDP/Market Cap fails to acknowledge this basic change.

#4: Varying Sectors/Growth Rates Across Time. In 1980 the largest US public companies were Exxon, GM, Mobil, Ford and Texaco. That list didn’t change much in 1990 (IBM and GE squeaked in).

Now, the largest domestic public companies are Apple, Microsoft, Amazon, Google and Facebook. None are reliant on commodity prices or cyclical demand or face still competition from foreign rivals. Almost all show above-average profit margins. All are global in scale. But Market Cap/GDP implies they should be worth the same as an oil company or car manufacturers, at least in the aggregate. That makes no sense to us.

Summing up: We don’t use Market Cap/GDP to measure equity valuations for all the reasons noted here. That’s not to say US stocks are cheap; we all know they are not. But Mr. Buffett’s favorite indicator is long past its sell-by date, even if the man himself is clearly still at the top of his game.

More information on the indicator here: https://www.businessinsider.com/what-is-the-warren-buffett-indicator-2017-12