Known as the “Oracle of Omaha,” Warren Buffett is considered one of the most successful investors in the world, having started at a young age and amassing an impressive $89 billion as at the end of 2019.
His disciplined and consistent approach has made him the fourth-wealthiest person in the world and so investors often look to him for wisdom and advice in how they can improve their returns.
Being a value investor, Warren Buffett relies on analysing individual stocks as well the performance of the overall market to find undervalued stocks that will perform well over the long term.
As part of this analysis, he relies on a number of indicators and analytical methods to calculate whether a market or stock has been oversold or overbought. When markets are expensive, he sits and waits patiently until markets become oversold, before aggressively buying the many bargains that are available.
In 2001, Warren Buffett was being interviewed by Fortune Magazine where he revealed he uses a particular metric to get an overall feel for the valuation of the US stock market. He described it as “the best single measure of where valuations stand at any given moment.”
The best thing about this measure is that it is very easy to calculate and use, so it is a useful addition to every investor’s toolkit.
The Warren Buffett Indicator
Over the long run, stock markets will revert to prices that are determined by the cashflows of the underlying businesses. While traders may buy and sell to each other pushing prices to high and low levels, ultimately they are purchasing stocks which are fundamentally driven by how much the underlying business is growing or shrinking.
As a result of this dynamic, Warren Buffett uses a simple measure to determine if markets have distanced themselves too much from the mean and it is time to be cautious or aggressive. Since Warren Buffett was the first to bring it to mainstream attention, this simple measure has been dubbed the “Warren Buffett Indicator.”
Calculating the Warren Buffett indicator is very easy. You take the stock market capitalisation of a country’s entire stock market and divide it by that country’s Gross Domestic Product (GDP). The end result will be a ratio in percentage terms.
How To Use The Warren Buffett Indicator
By comparing the ratio to different periods in history, traders can get a feel for whether a market is currently expensive or cheap.
For example, during the 1982 recession in the US, the ratio dropped to 35% while during the US tech bubble of 2000, the ratio reached 148%. This shows how in the span of just 18 years, the market went from extremely undervalued in 1982 to extremely overvalued by the end of 2000.
More recently, at the end of 2019 the Warrant Buffett Indicator was around 145%. This indicates an expensive market relative to history, suggesting traders may benefit from being cautious.
By being aware of these moments when the ratio is extremely high or low, traders can make sure they adjust their risk exposure to protect against market falls and leap onto market opportunities.
Always bear in mind however, that no metric is ever 100% reliable. There will be times when it gives false signals and other times where it will predict an event to a scarily accurate degree. If this wasn’t the case, the perfect indicators would already have been discovered and traders would know exactly when to buy and sell.
The Warren Buffett Indicator is no exception. While it will routinely go above 100%, it may stay that way for long periods of time. For example, since 2014 the Warren Buffett Indicator has remained above 120%. When you consider that it was 110% just before the Global Financial Crisis (GFC) in 2008, you can see why it’s not always a guarantee of a market top.
On the flip side, the GFC bottomed out only once the ratio hit 50%, while during the tech bubble it fell to 35%.
As the old saying goes, sometimes markets can remain irrational longer than you can remain solvent. It’s best to use the Warren Buffet Indicator to get a feel for where the market currently is and to manage your risk and portfolio positioning accordingly, rather than relying on it as an indicator of market tops and bottoms.
Where Is The Warren Buffett Indicator Today
Today, the Warren Buffett Indicator stands at greater than 140%. This is one of the highest rates in history. While that in itself might be cause for worry, remember that this isn’t a market top or bottom signal. Valuing the stock market takes more than just one indicator. Stocks can absolutely keep muscling away higher, ignoring underlying fundamentals as greed takes over.
Warren Buffett himself said it best when asked about his favourite metric at Berkshire’s 2017 annual meeting. He said that “It’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.”
Things like historically low interest rates and declining corporate tax rates are serving to distort traditional measures of fair values so while it pays to be prudent with such a high rating, it’s no cause for panic yet.
Conclusion
Named the Warren Buffett Indicator after perhaps the world’s greatest investor, Warren Buffett, the indicator is calculated by taking the ratio of market capitalisation vs GDP.
This ratio is used to determine whether markets are cheap or expensive relative to historic averages. Generally speaking, values above 100% are considered overvalued, while values below 80% are considered undervalued.
Like all indicators, the Warren Buffett Indicator should not be relied upon in isolation, as there are periods when the indicator can stay elevated or depressed for years at a time.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
