Thursday, February 5, 2009

Buffett's Stock Market Indicator

It makes a lot of sense that the aggregate value of a country's stock market should be correlated with its Gross National Product (GNP). Assuming the stock market contains most of the country's largest companies, the value of what those companies produce should constitute a large part of GNP and should also play a large role in determining what those companies are worth, hence the suggested correlation.

In this 2001 article, Buffett argues that while "the [stock market value to GNP] ratio has certain limitations in telling you what you need to is probably the best single measure of where valuations stand at any given moment."

Here's a look at this ratio for the last several decades, as compiled by Carol Loomis and Doris Burke of Fortune:

What we see from the above chart is that stocks now have come down to a more normal historical value, after years of outperforming GNP! Indeed, even after the tech bubble burst, stocks were still expensive, and only after another bull market to 2007 did they come 'crashing' down to today's seemingly normal levels.

Of course, relying completely on this chart could lead one astray. As the market has become more sophisticated over the decades, there may now be a greater percentage of companies that are public, which would lead to an upward trend to this chart rather than a horizontal line. Public sentiment during certain periods may have also resulted in a skewed public to private comany ratio. For example, if we look back at the years during the Great Depression, it is likely that many companies, even many successful ones, remained private for lack of cheap public capital.

Nevertheless, this chart is immediately useful for demonstrating that over the last several years, stocks are clearly trading at a discount to what they were after even after accounting for a drop in the value of goods produced.


Unknown said...

What is your take on the argument, that american firms (KO, PEP, MMM, MSFT..) have a much higher proportion of international sales that could justify a hiegher ratio?

Saj Karsan said...

Hi Matias,

This would be more of a concern if using GDP (goods produced within the US), but in this case by using GNP (which includes foreign income) we are taking that into account for the most part.

Anonymous said...

The ratio still looks high if you consider that interest rates are at all time lows and corporate profitability was recently at an all time high.

Were these two metrics to return to historical averages, stocks should get much cheaper relative to GNP.

Is it time to buy? Maybe, but not because stocks are necessarily 'cheap'.

Anonymous said...

Mathias: there are also more foreign companies selling goods in the US, either through importing them or by producing them in the US. Those companies' MV is counted in their home country, not in the US, although I wonder if the value of ADR's is included in the value of the US "stockmarket". Overall, and as a back of the envelope measure, all these factors probably cancel out against one another, leaving the gross measure of "Stock Market Value vs. GNP" pretty acurate.

FM said...

I was surprised to read Buffett say that buying stocks at 70%-80% of GDP would work well considering the long-term average is more like 60% and tends to dip to 40% or less in severe recessions.