BUFFETT’S FAVORITE VALUATION METRIC SAYS….

The most recent update to Warren Buffett’s favorite valuation metric is showing some fairly encouraging signs.   For those who aren’t aware, Buffett is quoted saying that the total market cap vs GNP is one of his preferred valuation metrics.  The current reading of 89% is still above his preferred buying range (70-80%), but well off the highs we’ve seen in the last 15 years.  Buffett has previously explained his thinking behind the indicator:

“For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000– you are playing with fire.”

So stocks aren’t cheap, but they’re also not terribly expensive based on this measure.   If the recent trend holds we could be nearing Buffett’s preferred buying range in the coming years….

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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  • CCV

    What index are you using here?

  • LVG

    Cullen, you have to read the latest from Wray. It will drive you up the wall. He says capitalists are like undertakers. I think he’s losing it. http://neweconomicperspectives.org/2012/06/mmp-blog-51-the-efficiency-fairy-and-inflation-goblins.html

  • http://www.pragcap.com Cullen Roche

    Saw it earlier. This idea that capitalists are job destroyers exposes a recklessly flawed understanding of basic economics. Hell, I am not even an economist and even I understand how innovators optimize time and create more demand in the future by making us all more efficient. This allows us to consume more, produce more, employ more people, etc, etc. It’s shocking how both sides of the aisle misunderstand this point. See the section in here on entrepreneurs. http://pragcap.com/understand-the-modern-monetary-system/understanding-modern-monetary-system

  • VII

    Do u guys enjoy reading that stuff?
    I took a look at the article and the responses and I felt like someone invited me to the local city council meeting that was discussing how high the code for light illumination allows at the local big box store. Where by the usual foes bicker for 6 hours.
    No one is getting laid on that site. I mean if u want to make sure u spend your life alone with a cat and a computer I would recommend you become a regular at Wray site discussing and arguing with him on economic theory’s. Life is short make sure you waste it there.
    What’s the opposite of snorting cocaine off a strippers a$$? I’d have to say Wray site.

  • Notagain

    Not sure what this metric measures? Valuation/sales ? so what ?

  • B Ferro

    Hilarious…

    Reminds me less of a local city council meeting and more about this scene from Good Will Hunting…

    We all know who has the pony tail…

    http://www.youtube.com/watch?v=QnZ0Y4rvz6E

  • http://www.riskandreturn.net Lance Paddock

    I never quite got Buffet’s explanation there. I think it is a reasonable valuation tool to have in the box, I just don’t get his comments. Just look at his chart. If you look at it stocks were almost never too expensive prior to the late 1990′s if 70-80% is cheap. Yet we know he felt the market was wildly overvalued in the second half of the sixties and early seventies. He even returned his investors money during that time and waited until the 1974 bear market to go in whole hog.

    I think his comment was off the cuff and likely unrepresentative of his real use of the metric.

  • Nils

    Well at least you can’t get locked up for hanging out there. I can’t go back to the big house.

  • Nils

    Don’t see how this indicator can be useful to people operating within a timeframe that doesn’t go past their lifespan.

  • Nils

    Might be helpful if you already have a few targets that correlate strongly with the overall market you want to acquire, but I wonder if the timing isn’t better when you just buy when the indicator goes up again. Calling bottoms is tough.

  • Chris of Stumptown

    Companies have replaced equity with debt. The chart measures equity capital only. Therefore I claim the chart is misleading.

  • asha101

    that means stocks are cheap. You can not judge stock valuation without comparing to interest rates.

  • asha101

    that means stocks are cheap. You can not judge stock valuation without comparing to interest rates.

  • Chad Starliper

    Cullen

    That chart looks off a bit.

    Flow of Funds 2012-Q1 data: Market cap of US nonfinancial corporate equity $16.1 bn; GDP $15.5 bn. Mkt/GDP = 104%. Adjusted for changes in monthly market cap since then, and assuming that nominal GDP is growing at a monthly annual rate of 4.5%, the ratio is still 104%.

    Using the Wilshire 5000 to GDP metric (see Guru Focus who updates this chart daily), the ratio is 93.3%.

    Since 1947, the flow of funds average is around 65%. However, if we assume that nominal GDP grows at an avg of 6% per year, and the “fair” value of market cap/GDP is 70%, then the 10-year expected annualized return is approximately 4.4% for US stocks, with a likely range between 1.6% and 6.7%.

    In some sense that could be decent relative to the expected return on investment grade bonds, but not at all cheap on an absolute basis…at least as I interpret the data.

  • Anon Jon

    I wonder if this metric is useful now versus say 30 years ago given how much international (or ex-US) earnings contribute to S&P500 earnings now… maybe a better metric would be total stock value globally versus global GDP

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Chad,

    Your numbers appear to be bang on perhaps we are quoting the same site:

    http://www.gurufocus.com/stock-market-valuations.php
    “The Stock Market is Modestly Overvalued. Based on historical ratio of total market cap over GDP (currently at 93.3%), it is likely to return 4.4% a year from this level of valuation. This page is updated daily with the market.”

    This website does a great job of explaining the relevance of the metric for those that are interested.

  • http://www.pragcap.com Cullen Roche

    They’re using GDP. I am using GNP, per Buffett’s preference. Not a huge change, but that explains the few % point difference. Same basic result and message though….Thanks Chad.

  • http://www.pragcap.com Cullen Roche

    Something to chew on. I don’t know Lance. I’ve honestly never found too much value in this metric, but I am not a value guy. I still think it can provide some perspective at extremes and it was bang on during the 2009 bear for those who bought per Buffett’s thinking….

  • Colin, S.Toe

    One problem is that ‘capitalist’ confounds two diametrically opposite types.

    I just learned that Thomas Brassey, the greatest RR man of all, was a builder of the Jim Hill type, who created so many jobs, and treated workers so well that they lined up around the block to pay respects at his funeral. He had no personal secretary (no tax comparisons there), but carried a writing case around with him so that he could immediately reply to correspondence.

    Jay Gould exemplified the influence and financial shell game mongering counter-type, for whom ‘hook worm’ might be a better comparison than ‘undertaker’.

    Beyond regulation, what is needed is a society astute enough to admire and reward the one, and despise and contain the other (behind bars, if necessary),

    The one mastered the power of money; the other, the power of people.

  • http://www.pragcap.com Cullen Roche

    True, but there are a lot more good capitalists in the USA than bad ones. The good ones understand that their products and services are only valuable if they benefit society. Ie, they give back. The bad capitalists lie, cheat and steal. Sometimes in legal ways. The bad ones muddy the waters for the rest….

  • Geoff

    With all due respect to Mr. Buffett, I’ve never liked this indicator. Not just for the reason mentioned by Jonny Anon above (the international aspect), but also because market cap only tracks public companies. If the ratio of private to public companies has changed over time, then this indicator is not very meaningful.

  • Dismayed

    Pretty radical stuff:

    “Unemployment destroys lives, families, and communities. It is bad for physical and mental health. It promotes crime, ethnic division, and even terrorism.”

  • http://www.pragcap.com Cullen Roche

    D, Are you defending Wray’s comments that capitalists are job destroyers? That we should just blame all the unemployment in the world on capitalists for undertaking the risk of starting businesses and trying to make a profit?

  • Matt

    The use of this metric has always baffled me, particularly by Buffett. It is most definitely not a pure valuation metric as it captures two things: the amount of outstanding publicly traded stock and the valuation of said stock. So a rise or fall in the metric over time could be attributed to either or both. Then there is the presumption that stock prices should track GNP over time, but there’s no real rationale behind that.

    I think this is just one of those odd instances where a brilliant person gets set on a flawed idea and can’t shake it.

  • SS

    Cullen – have you ever considered starting a fund or a premium service based on your algo? I think readers would love a way to access your portfolio management style more directly.

  • http://www.pragcap.com Cullen Roche

    Considered, yes. Doing, no.

  • Dunce Cap Aficionado

    Something about proximity and the third piece of a three peice suit?

  • Chad Starliper

    Matt

    The basic, unadjusted market cap-to-GDP model has a .77 r-squared to 10-year returns.

    The reason that it is useful is that GDP is a “smooth” proxy for the revenue base of corporations. While profit margins fluctuate, long-term earnings track very closely to nominal GDP – at about 6% p.a. So the value of equities (price) relative to its long-term “earnings base” does a nice job of looking at the valuation of the broad market. Also, GDP doesn’t suffer from the same volatility and accounting management that earnings do.

    Let me add a snippet of what has no bearing on long-term returns… the price/forward operating EPS metric. Now that is a useless piece of information that Wall St is in love with.

  • Boston Larry

    Cullen, I congratulate you on your algo’s BUY recommendation over the past 4 weeks. Equity markets hit a 5-week high today. The big question is whether the Fed will disappoint investors tomorrow (Wed.) by “only” extending Operation Twist by a couple of months. If that is all they do, then my guess is markets will sell off, at least for a day or two.

    I tend to lean to the bear camp, so it’s good for me to follow a reasonable optimist like you.

  • Nils

    I think he could totally pull off that vintage college professor look.

  • John

    See http://www.ibmemployee.com/PDFs/WarrenBuffettStockMarket.pdf at page 11 for a chart used by Buffett for this correlation. The 2000 peak is shown at 190%. You have 140%

    See another chart at http://www.ritholtz.com/blog/2011/03/market-cap-as-a-of-gdp-3/ that is comparable to the one used by Buffett.

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Chad,

    Excellent factoid.

    “Let me add a snippet of what has no bearing on long-term returns… the price/forward operating EPS metric. Now that is a useless piece of information that Wall St is in love with.”

    That is spot on. Agree with Hussman or not but he has totally demolished this so-called forecasting tool. This is just one of many of Wallstreet’s perpetual stock pumping metrics that have no basis in reality. Interestingly Hussman’s valuation metric, which does have predictive value, values stocks at a very similar forward return level.

    No one likes this Buffet metric because if you really followed it you would wait until stocks are at the 50% level or less to buy which is in the 800 range from today’s level. It really only tells you when to buy when others won’t and it doesn’t happen often so it basically goes against the interests of Wallstreet.

    To me this is just a variant of Fisher’s price to sales ratio (PSR) which I like. It doesn’t help with individual stocks but as history shows if the value gets low enough even a dummy can make money buying.

    Thanks for the insights. I appreciate them.

  • Ted

    Haha, the day that Neil Patrick Harris (the Harold & Kumar version) starts writing about economics will be the day that PragCap gets bumped down to my 2nd favorite blog.

  • Leverage

    Both interesting comments, off course nominal (asset price) growth permabulls (Wall St.) aren’t interested on this.

  • Johnny Evers

    THe logic of ‘buy low, sell high’ requires you to have the discipline to be out of the stock market for years at a time and the flexibility to find another market (maybe commodities today, certainly gold back in 1999) that is cheap.

  • Erik V

    The logic behind the chart is pretty simple. GNP represents the income of the entire country that supports the valuation of stocks. When the ratio becomes too high, it means there won’t be enough income to support the profits needed to justify the valuation. The period from about 1995 to the present was a serious of bubbles. When the current bubble pops we could be getting near the lows of this ratio which would result in a generational buying opportunity.

  • SB
  • SB