Should we brace for a long bear market?

When it comes to evaluating the stock market and determining whether it is overvalued or not, investors and analysts rely on various metrics and indicators.

These tools help them gauge the overall health of the market and make informed investment decisions. One such indicator that has gained significant attention is the Buffett indicator, named after the legendary investor Warren Buffett.

The Buffett indicator, also known as the market cap-to-GDP ratio, compares the total value of all listed equities in the market to the size of the economy. It serves as a measure of market valuation and helps investors identify potential opportunities or risks.

According to Warren Buffett, this ratio is “probably the best single measure of where valuations stand at any given moment.”

By examining the Buffett indicator, we can gain insights into the market’s relative overvaluation or undervaluation.

As a rule of thumb, the Buffett indicator suggests that a stock market is undervalued if its market cap-to-GDP ratio falls below 75 percent. Conversely, if the ratio surpasses 90 percent, it indicates that the market is overvalued.

These thresholds provide investors with a broad framework to evaluate market conditions and anticipate potential returns over longer time horizons.

But if we look at market history, we will find that a high Buffett indicator may suggest that a stock market could continue to strengthen and remain “overvalued” for an extended period. This is particularly true when long-term economic growth can justify stock price valuations.

Similarly, a low Buffett indicator may not necessarily mean that the market is already cheap, as stock prices may continue to weaken in the subsequent years.

For example, during the early stages of the bull market in 2006, when the Philippine Stock Exchange Index (PSEi) had more than doubled its value since 2003, the market cap-to-GDP ratio was already at the 90 percent threshold.

However, instead of correcting, share prices continued to rise for almost a year until the Buffett Indicator peaked at 106 percent in 2007.

During the global financial crisis in 2008, when the PSE Index had been falling for over a year and had lost more than 30 percent of its value, the Buffett Indicator broke the 75 percent threshold, indicating an undervalued market.

However, instead of recovering, the stock market fell further, dragging the Buffett Indicator to as low as 43.2 percent in 2009. This kept the market “undervalued” for the next two years until it started to rise above the 75 percent threshold again.

In 2012, when the PSE Index almost tripled in value from its bottom in 2009, the Buffett Indicator crossed the 90 percent threshold for the first time. However, instead of experiencing a massive correction, the PSE Index continued to advance further, keeping the stock market “overvalued” for many years until 2019.

Today, the Buffett Indicator, which represents the ratio of the PSE’s total market capitalization to GDP, stands at the threshold of 75.3 percent.

If we examine market history, it is likely that this indicator will drop below the 75 percent mark that could potentially keep the stock market “undervalued” for an extended period of time.

There are two factors that will contribute to this decline: the declining national savings rate and the increasing financial risks.

Our national savings rate has been steadily deteriorating, dropping from a high of 20.7 percent in 2010 to a mere 7.6 percent today.

A low national savings rate indicates that there is less money available for investments in productive assets, which can result in higher levels of debt.

An increased reliance on borrowing can lead to higher interest rates, further amplifying the financial risks in the market. During the 2007 financial crisis, the ratio of debt of PSE listed companies to the market cap was only 12 percent. The high savings rate at that time and low financial risk contributed to the strong recovery of the stock market.

Over the years, the ratio of total debt-to-total market cap in the PSE increased to 34.7 percent in 2017, and just before the pandemic struck at the end of 2019, this ratio accelerated to 50.2 percent.

The significant accumulation of debt in recent years, driven by low interest rates, has raised financial risks to unprecedented levels. Currently, the ratio of debt-to-market cap of PSE companies is estimated at 62.4 percent.

Correcting these imbalances will likely take some time, as deleveraging is a gradual process that requires careful management to mitigate adverse effects on overall economic activity.

In the meantime, if the Buffett Indicator drops below the 75 percent threshold, the stock market could continue on a declining path towards its previous historical low of 40 percent.

The Buffett Indicator serves as a valuable tool for investors. By understanding the dynamics of market cap-to-GDP ratios, they can make more informed choices and successfully navigate the complexities of the stock market. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 102nd batch of RFP program this July 2023. To register, email [email protected] or text at 0917-6248110.