BUFFETT’S FAVORITE VALUATION METRIC: STOCKS ARE MODESTLY EXPENSIVE

Warren Buffett was famously bearish in the late 90’s and has happened to be very bullish at some of the most opportune moments to be buying equities.  The world’s most famous investor claims to have no market timing ability, but still manages to make remarkable deals when stocks are severely depressed.  His latest ventures into Burlington Northern and Goldman Sachs are two notable crisis purchases that, in retrospect, appear like remarkable cases of market timing.

In a famous Fortune magazine article in 2001 Buffett disclosed his favorite market valuation metric and showed why he was bearish in the late 90’s and bullish at the time of this writing (which proved prescient again):

“On a macro basis, quantification doesn’t have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country’s business– that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.

For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won’t happen.”

Buffett elaborated on the index explaining that stocks were cheap when the ratio declines to 70%-80%:

“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.”

The latest recession also shows why Buffett might have been making such bold calls in the latter portion of 2008 and in 2009.  The ratio had declined to the desired 70%-80% that Buffett described in 2001.  Since then it has skyrocketed higher and now sits at the 105% level – just slightly overvalued.  Of course, as we saw in the late 90’s and during the housing boom valuations can become extremely stretched, however, the lesson from past occurrences is that future risk adjusted returns tend to be poor when the ratio is at such levels.

Following the 100% reading in 1997 you experienced 3 extraordinary years in the market before the Nasdaq bubble collapsed and valuations tanked.  Ultimately, over the ensuing 10 years your average annual return equaled +5.31%.  If you held until today you averaged +2.31% per year.   Since crossing the 100% mark in 2006 the S&P 500 has returned an average -1.53%.  Of course, while long-term returns have been less than stellar, both the 2006 period and the 1997 period show that markets can become severely overvalued before correcting.  This likely means that long-term returns are likely to be below average for investors who are currently buying, however, speculative fever could reward these investors in the near-term.