The Buffett Indicator is a renowned metric used to assess whether the current stock market is overheated or undervalued. It was highlighted by the legendary investor Warren Buffett in a 2001 interview with Forbes magazine. This indicator measures the ratio of the total market capitalization of the stock market to the Gross Domestic Product (GDP). Buffett pointed out that this ratio is the best indicator for determining whether the overall stock market is overvalued or undervalued. This indicator often appears in various media reports, especially when the figures are at extreme levels.
Buffett Indicator = Total Market Capitalization ÷ GDP
The Buffett Indicator is a basis for judging whether the overall stock market is overvalued or undervalued. Warren Buffett, during his interview with Forbes in 2001, stated:
“The percentage of total market cap (TMC) relative to the US GNP is probably the best single measure of where valuations stand at any given moment.”
This means that the ratio of total market capitalization to GNP is the best method to assess the value of the stock market at any time.
Three factors determine the long-term return rate of the stock market
Key factor 1 in determining stock market returns: Interest Rates
Interest rates act on the stock market like gravity. The higher the interest rates, the greater the downward pull on the stock market. This is because the return investors expect from any investment is related to the risk-free rate obtainable from government bonds.
For example, suppose the bank interest rate is only 1%, then a bond with a 6% yield (which takes risk) may seem relatively attractive.
However, if the risk remains the same and the bank deposit rate rises to 6%, then you would not be interested in investing in other assets with higher risks unless they offer higher returns (lower prices).
Therefore, when government rates rise, the prices of other investment assets must adjust downwards to meet investors’ expected return levels. Conversely, if government rates fall, the prices of other investment assets will rise.
Key Factor 2 in Determining Stock Market Returns: Long-Term Profit Growth of Companies
In the long term, the profitability of a company tends to revert to around 6%. During economic recessions, a company’s profitability declines; during economic growth, profitability increases.
However, in the long term, the overall profitability of companies tends to approximate the long-term economic growth rate.
The size of the U.S. economy is measured by Gross National Product (GNP). Although GNP is different from GDP,
the difference between them is within 1%. For the sake of calculation convenience, GDP can be used.
Key Factor 3 in Determining Stock Market Returns: Market Valuation
In the long term, stock market valuations tend to revert to their median. If the current valuation is too high, it indicates that future long-term returns will be lower.
If the current valuation is low, it suggests higher future long-term returns.
The overall reasonableness of stock market valuations can be assessed by the ratio of total stock market capitalization to GDP.
If the ratio is between 70-80%, it implies undervaluation, making it a good time to buy stocks; if the ratio exceeds 200%, the stock market is extremely risky, akin to playing with fire.
Based on past experience, the Buffett Indicator is divided into five stages to assess market value.
Ratio <= 72%, indicating the market is severely undervalued.
72% < Ratio <= 93%, indicating the market is slightly undervalued.
93% < Ratio <= 114%, indicating the prices are reasonable.
114% < Ratio <= 134%, indicating the market is slightly overvalued.
Ratio > 134%, indicating the market is severely overvalued.