There are many ways to tell if the stock market is overvalued or not, but here is one ratio that is “probably the best single measure of where valuations stand at any given moment,” according to legendary investor Warren Buffett.
Known as the Buffett indicator, this ratio, which measures the total value of all listed equities in the market relative to the total size of the economy, can predict market returns over longer time horizons.
By rule of thumb, the Buffett indicator says that a stock market is undervalued if its market cap-to-GDP (gross domestic product) ratio falls below 75 percent, and overvalued if its ratio goes above 90 percent.
According to this theory, a stock market with low market cap-to-GDP ratio could result in above-average investment returns over subsequent years, while a market with high ratio could produce years of disappointing returns
But, like in pricing multiples, we know that a high Buffett indicator does not always mean the market is going to crash soon. In the same way, a low indicator does not necessarily mean the market is cheap.
Market history has shown that a stock market with rising Buffett indicator can, in fact, get stronger and even stay “overvalued” for an extended period so long as long-term economic growth can warrant stock price valuations.
For example, during the start of the bull market in 2003, the market cap-to-GDP ratio was already above 90 percent when the Philippine Stock Exchange Index (PSEi) started to move up.
The rise in the share prices pushed the Buffett indicator to above 100 percent the following year and never looked back until it peaked at 147 percent in 2007.
During those years, there were two factors that supported the high Buffett indicator. One was the increasing level of savings as a percentage of GDP, which averaged at 18 percent at that time.
The other was the decreasing financial risks, which lowered the ratio of total loans-to-GDP from 107.8 percent in 2003 to 82.6 percent in 2007.
Basic economics will tell us that in a growing economy, when people save more, banks are able to lend more from savings to finance long-term investments, creating a positive cycle of economic growth.
Although the Buffett indicator fell to its lowest level at 54.6 percent at the height of global financial crisis, lower financial risk and strong savings ratios of the economy enabled the stock market to recover quickly in 2009.
During the second bull market of 2009-2019, the Buffett indicator crossed the 100 percent level again and stay “overvalued” for years until it peaked at 112 percent in 2015.
By this time, the national savings ratio started to go down to 15.8 percent while the ratio of total loans-to-GDP increased to 135 percent, as interest rates sank to historical lows from prolonged monetary easing.
The decline in savings ratio and increase in financial risk set off the long-term downtrend of the Buffett indicator in 2016.
By 2019, when the PSEi began to fall, the Buffett indicator has already dropped to 90.7 percent. The savings ratio further weakened to 13.5 percent, while financial risks increased with higher ratio of total loans-to-GDP at 180 percent.
This year, the Buffett indicator declined to its lowest level in 10 years at 68.7 percent after the stock market collapsed due to the coronavirus outbreak.
The contraction in the economy in the first six months of 2020 has worsened the national savings ratio to only 6.6 percent, while financial risk increased to a record level with total loans-to-GDP ratio of 216 percent.
While a low market cap-to-GDP ratio may indicate that share prices are low now, past market experience will show that a declining Buffett indicator with rising risk and lower savings can make the stock market weaker.
If a rising Buffett indicator could justify a stock market to stay overvalued for years, the same falling indicator can also make the market undervalued for a long time.
Until higher valuations are warranted by improving economic fundamentals, continued contraction in the economy amid the ongoing pandemic can only suggest that stock market valuations will be lower in the months ahead. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 86th batch of RFP Program in October 2020. To register, email info@rfp.ph or text at 09176248110