Wednesday, January 6, 2016

What is the Buffett Indicator?

Market Cap to GDP is a valuation indicator that has been popularized by Warren Buffett, who claimed back in 2001 that "it is probably the best single measure of where valuations stand at any given moment."

Apparently, Warren Buffett thinks that the combined value of all stocks, as measured by the Wilshire 5000 Total Market Index, should be worth less than the Gross Domestic Product (GDP) of the U.S. economy.

Using this approach, this ratio generated a sell signal for the stock market in 2000, 2007, and again in 2015. It's important to note that it's not particularly effective as a short term timing mechanism, but that after the 100% threshold was exceeded, the future returns (12-to-18 months out) tended to be fairly bleak.

Here is the most recent reading for December 2015 (source). As you can see, it recently pierced the 2 standard deviation level (120% of GPD) and turned lower, suggesting future returns will not be attractive:

Updates will be provided on a regular basis, as well as analysis and insights for what it means for the stock market.