Media: Buffett’s Favorite Valuation Indicator & Recession Risk

I was fortunate to have been invited on Yahoo Finance’s Daily Ticker with Lauren Lyster last Friday in New York to discuss the markets, QE, recession risks and Buffett’s favorite valuation indicator and why all of this matters.  It’s only 5 minutes, but we cover a lot of ground.

Here’s a brief summary for those who don’t want to listen to me ramble:

  • The risk of QE is the disequilibrium it creates through the wealth effect and the potential for asset prices to deviate from their underlying fundamentals.
  • But how do we know what that’s occurred?  It’s not easy obviously, but the Buffett valuation metric might help us better understand when this is occurring.
  • The market cap:GNP ratio has only breached the 100% level 3 times.  It occurred in 2007 and during the 97-99 period.  This year was only the 3rd time it has ever breached it.
  • I discussed the Orcam Recession Index briefly and how the worst market downturns tend to occur within a recession.  This has kept me from turning into a cyclical bear through much of the recent rally in stocks.
  • Where is the market going from here in the near-term?  Who knows.  But the market tends to rally about 7% per year so our current 40% annualized trajectory is not the norm….
Click the image below for the full video.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • FrankH

    You really like the double windsor knot, eh? Guess you gotta look good on this show. ;-)

  • Geoff

    I love Lauren.

    Cullen, you did OK, too.

  • Valuation Consultant

    I think this is your best film appearance yet! Great job.

  • Ballast

    Cullen, would you mind providing links to the two graphs shown in the presentation, market cap relative to GNP, and the recession index? Thanks!

  • Jay
  • Jay

    Agreed…nice job, Roche :)

  • Frederick

    Agreed. Nice job CR. Nice and balanced view. You did a good job keeping it concise. Still some hand waving going on though! :-)

  • rbutys

    ” This has kept me from turning into a cyclical bear through much of the recent rally in stocks.”

    Hate to call you out, but I have been noticing this and similar comments I’ve seen lately on the site — they seem like spin to me. I respect the site bc it seemed honest with itself, suggesting the ability to learn from past mistakes.

    Let’s just say you were semi-correct at best in that you said there would be likely be no market crash due to the amount of government spending, but you also never predicted anything close the rally and new highs we’ve had — Specifically, you suggested that the markets would muddle through and gov spending was offset by the tattered balance sheets of households — and also that QE would not create rising asset prices because it was simply shortening the time horizon of money that already existed and was actually anti-inflationary bc of the loss of interest payments.

    To now say that QE could be creating asset prices that are out of whack with fundamentals as you did on that show means you were wrong before and that it turns out QE did, in fact, lead directly to higher stock prices. I am not positive one way or another whether this is true (i.e. are higher stock prices due to QE or something else), but it if is, then I would respectfully ask if you could please explain why you were wrong before about QE and its effect on stocks, and if your understanding has changed now.

    Because I think a lot of the visitors to this site are centrally focused on the direction of the overall market, I think this is a central question.

    Thanks, great job generally as usual!

  • Ryan Melvey

    I really don’t understand this metric. If the amount of companies going private increases won’t this metric get distorted over time?

  • Cullen Roche

    Let me see if I can clarify/help. First, I am rarely, if ever, “all in” on stocks so if you ever get the impression that I am a raging bull you’re probably wrong. But anyone who’s an actual client of Orcam or the research knows exactly how my approach works and knows that I have been long within the vast majority of my portfolio due to the macro non-recessionary environment. I don’t discuss any of this in any specifics here at Pragcap so there’s no way any reader could possibly know how I’ve been positioned. So, no offense, but it’s impossible for any Pragcap reader to know about my portfolio positioning without having read the Orcam research or having been a client.

    Almost all of my commentary here is about macroeconomic trends. And my message has been incredibly consistent. The private sector growth is being driven primarily by the budget deficit and the budget deficit is playing a HUGE role in the corporate profits picture due to the Balance Sheet Recession). I said QE, on its own, would have no REAL impact on stocks other than a psychological impact. I’ve ALWAYS said QE could distort market prices, but would not drive cash flows or fundamentals in any material way. What I was specific about was in saying that QE would not be a FUNDAMENTAL driver of higher stock prices.

    Here’s what I said 2.5 years ago. What I should have been very clear about in this specific post (and was in other posts at the time) was that the primary driver of corporate profits and real underlying fundametnal growth was the budget deficit and NOT QE:

    All in all, it’s been proven that QE has little to no impact on the real economy. It does not boost lending and it does not boost aggregate demand. The problems here remain one of the real economy. Ben Bernanke believes he can induce a “wealth effect” by making risk assets more attractive, however, without real underlying improvement in the economy there is no long-term gain to be had here. Investors who buy risk assets based on the misconception that QE will fix the real economy will surely find out that real end demand remains weak regardless of QE intervention. Without real underlying economic improvement any bid in risk assets will certainly be temporary. Thus far, there is very little evidence showing that QE will improve real economic conditions. The Fed continues to tinker with various tools that simply paper over our problems. Inducing a psychological effect on asset prices and keeping prices “higher than they otherwise would be” might make us all feel better in the short-term, but I am highly skeptical that this sort of market intervention will lead to sustainable economic growth. At the end of the day, we must see an increase in aggregate demand that leads to higher corporate revenues that leads to hiring that leads to real economic recovery. If you’re banking on QE to generate real end demand you’re mistaken.

    Hope that helps. Sorry if I come across as trying to have it both ways. That’s certainly not what I intend to communicate. Admittedly though, I am willing to accept that QE does more in real terms than I’ve given it credit for….I’ve probably been overly dogmatic about its lack of impact….

  • SS

    Cullen’s been saying monetary policy doesn’t work in a balance sheet recession but that fiscal policy definitely works. I think Europe has proved him right since the austerity countries have collapse despite the ECB’s efforts while the nations that have continued spending have stayed afloat. Stocks just reflect that general thinking.

  • RayRay

    Where’s the golden tan and the sun shining on your face?

  • Dragon

    The market cap to GDP ratio needs to be re-computed to account for our national debt. In 99 and 07, our debt to GDP was much lower compared to now.

  • Rademaker

    CR, you said you would start worrying if this metric went up from where it is now, but from how I look at it, it would need to get cut almost in half to revert to the historical mean (60% according to So if we take this metric seriously we’re way past the point at which its reasonable to start worrying.

  • Tom Brown

    Another good show Cullen. You’re getting better this. Is Lyster the host of this show now?

  • SS

    Shouldn’t we expect this ratio to trend higher over time? The total market cap of the stock market should outperform GNP shouldn’t it? Just eye balling GNP vs Wilshire 5,000 returns it looks like the market index will outperform GNP by a few % points every year. Maybe this index needs an adjustment to be useful because I don’t think the current reading reflects anything more than the fact that market returns have outpaced GNP for a long time.

    Am I wrong?

  • Len Riddell

    Far be it for me to question Warren Buffett, but the market cap to GNP metric strikes me as a complete anachronism. The GNP should be adjusted for the US’s spiraling debt and the market cap is increasingly skewed towards overseas earnings (ie nothing whatsoever to do with US GNP). Relying on this metric for investment decisions seems dangerous to me…

  • Boston Larry

    Nominal versus real explains why GDP can and often does keep pace with stocks. Since we have about a 2.3% inflation rate, you must add that to the rise in real GDP to the the annual gain in nominal GNP. So nominal GNP is rising between 4% and 7% a year.

    You are right the even inflation adjusted that is still slower than the US long-term average increase in the S&P 500 index, which is between 8% and 9.5%. So it seems like this ratio will, and probably has, tended to increase over long periods of time. Maybe 100% is “the new normal” for this ratio. What say you, Cullen?

  • Boston Larry

    Net worth = total assets minus total debts. The total value of all private assets in the USA is estimated at about $60 trillion. The US government public debt is $ 16 trillion. Total private debts of all Americans is about $24 trillion. So the net worth of all Americans is still positive, 60 – 24 – 16 = about $ 20 trillion in net worth. In spite of the huge run-up in gov’t debt, over the last 12 years the net worth of Americans has increased. All this has nothing to down with GNP, which is our national income. Income = Output. The ratio is stock market value to national income. That has nothing to do with either assets or debts. Over the long run Americans have done well, and will likely continue to do well, in spite of all the hysteria over government debt.

  • Tim

    I think the gauge of market cap:GNP is skewed by the large amount of cash that companies are holding right now.

    GDP = 16.5 trillion
    Cash holdings: about 2 trillion

    If you back out that cash or even just 75% of it, the ratio is at 90% thereabouts….(these are back of the napkin calculations I am doing….and I’m using the ‘net as a source…so don’t crucify me if my numbers are a little off…)

    I think the rally in the context of this ratio is misinterpreted.

    In the context of this ratio, with companies holding this amount of cash, there’s room to run.

  • LVG

    You need to look at households only. Businesses are not counted in household net worth because it makes no sense to subtract business net worth from household net worth since we live in a world of people and not corporations. The thing that confuses a lot of people is that a huge stock of these household financial assets are liabilities of corporations. So that corporate debt and stock is a liability not of a person, but of a corporation. This is really important because, as Cullen always says, most of our liabilities are just claims against entities and not other people. That doesn’t mean they don’t matter, but it’s not like some person is on the hook for all the liabilities in the private sector. Most of those liabilities exist on a corporate balance sheet in the form of debt or stock issued. This is very different than you taking out a loan to finance a house. When a corporation sells stock to finance its operation it issues securities that increase the net worth of the non-business non-financial sector. This makes us all better off assuming the corporation is viable. Some theories like M M T misunderstand this because they’re too busy demonizing corporations as they repeatedly say “private sector surplus is public sector deficit”. MR should start its own mantra saying “non-business surplus is MOSTLY business deficit”. It’s equally true and twice as important to understand.

  • LVG

    Just running some rough figures on this thinking. Household net worth is basically broken down by government deficit + corporate deficit + foreign deficit. Total household net worth is roughly 60 trillion of which 30 trillion or so is corporate deficit. Another 16 trillion is government deficit. And the remainder has to be foreign deficit plus mostly real estate appreciation. Of this, the government’s deficit is by far the smallest piece so household surplus is really made up of mostly business & foreign deficit in addition to homeowners equity.

    Very rough, but close enough. I still can’t believe M M T gets away with describing that 16 trillion slice as being the most crucial piece.

  • Geoff

    Nicely broken down, LVG. It really helps put things in perspective. The 16 trillion “Net Savings” is not a very meaningful number. It certainly pales in comparison to the $60 trillion in household net worth, which is our true spending power. Our borrowing capacity is also based largely on net worth, which is crucial given our bank run monetary system.

    Final point, the big bad $16 trillion govt deficit doesn’t look so scary when you consider household net worth is $60 trillion!

  • Geoff

    I meant $16 trillion govt DEBT.

  • ann rand

    the problem is when you look at the amount of GDP made up by the government deficit which is currently at 10% of GDP it distorts the multiplier. The market is at least 110% of real GDP

  • rbutys

    Appreciate the response