Are we headed for a bull market or a bear market? What exactly will happen with stocks in the future? There are plenty of popular indicators and metrics that help answer questions like this, but one of the best known was developed by Berkshire Hathaway chairman and CEO Warren Buffett: The Buffett Indicator.
Buffett developed this in the midst of the 2001 tech crash, telling Fortune magazine at the time that his formula was “probably the best single measure of where valuations stand at any given moment.” Although he has since walked that back in the years since, many pros still put the Buffett Indicator among the best tools for assessing how cheap or expensive the aggregate stock market is.
What is the Buffett Indicator?
The Buffett Indicator is a ratio that puts the U.S. stock market value (typically measured by the Wilshire 5000) against the national gross domestic product, or GDP. In other words, the metric is essentially a market capitalization-to-GDP ratio that divides the stock market value by the GDP. For some background, market value is the price at which a security or company stock would trade among investors in a competitive market setting.
“Having this additional insight into future stock market returns is useful not just for portfolio management decisions, but also for a variety of financial planning purposes.”
— Paul N. Winter, Certified Financial Planner, Five Seasons Financial Planning
The ratio between these two data points, or the Buffett Indicator ratio, represents the expected future returns relative to current market performance — with a percentage point representing just how over, or undervalued, the stock market actually is. For example, on July 31, the aggregate U.S. market value was $48.97 trillion, while the annualized GDP was $26.91 trillion. If you were to divide market value by GDP, you would be left with a ratio of 182%, which is approximately 51.3% above the historical trend line, suggesting that the stock market is overvalued compared to GDP, according to data from Current Market Valuation, which tracks various economic models to determined the state of the U.S. stock market.
Whether by the Buffett Indicator or another measurement, Paul N. Winter, a certified financial planner at Five Seasons Financial Planning in Salt Lake City, says he agrees that valuation is one of the best ways, if not the best way, to estimate future stock market returns going forward over the longer term.
“The higher the current stock market valuation is, the lower we should expect future stock market returns to be,” Winter says, adding that “in turn, having this additional insight into future stock market returns is useful not just for portfolio management decisions, but also for a variety of financial planning purposes, and most notably in performing retirement projections.” He adds: “I don’t use the Buffett Indicator to the exclusion of other indicators of stock market valuation,” but it is important for advisers to know.
Other things stock market investors may want to consider
While the Buffett Indicator can indeed add some useful perspective, there are dozens of alternative strategies out there to measure valuation, pros say. And, of course, it’s worth it to talk to your financial adviser about how they look at these issues. (Looking for a financial adviser? This tool can help you to get matched with a financial adviser who might meet your needs.)
With interest rates rising steadily over the past year, low-risk investments such as bonds are paying relatively low returns and demand is often low among investors. Often risk-averse investors are poised to invest more in CDs or hold their cash in high earning savings accounts, many of which have seen improved rates over the period.(See some of the best CD rates you may get now here.)
That said, rates and markets typically move inversely of one another for two reasons. For one, as interest rates rise, firms who want to borrow more must pay more to make their interest payments, which in turn generally lower corporate profits. Because of this phenomenon, demand for company stock may also drag as investors are more likely to earn higher yields investing in debt products. Keep an eye on rates and you may have a better perspective on how valuable the broader stock market is at any given time.
S&P 500 price-to-earnings ratio
Also known as the P/E ratio, this stock analysis ratio is best used to determine the value of an individual company by comparing its price to its earnings and configuring how much someone is willing to pay for each dollar earned. Track this ratio against indexes such as the S&P 500 and you can gain insight into the broader stock market’s P/E ratio.
To be sure, the current 10-year S&P 500 P/E ratio is 31.4, which is today 55.7% higher than the modern-era market average of 20.2. By this metric, the stock market is significantly overvalued, according to Current Market Valuation.
Shiller P/E ratio (aka CAPE ratio or P/E 10 ratio)
Also known as the CAPE ratio, the cyclically adjusted price-to-earnings ratio is a valuation measurement made popular by Yale University professor Robert Shiller that relies on the earnings per share metric over a 10-year period. This long-term analysis is often used to account for fluctuations in corporate profits. Much like the Buffett Indicator, this ratio is designed to determine whether the market is either under or overvalued. In this case, you would divide a share price or a given company stock by the 10-year moving average, inflation adjusted earnings.
S&P 500 mean reversion
Mean reversion suggests that if the stock market showed a positive change when it comes to its actual returns, then it would cause a negative change as a result, and vice versa. In other words, stock traders calculate the mean, or the average price of a stock over a certain period of time, which is represented as a simply moving average (SMA). Since that SMA moved up and down over time, mean reversion suggests what goes up, ultimately comes back down over that determined window of time. When price is below the historical average, then any given stock would be considered undervalued. When it’s above the average, then it would be inversely overvalued. By running this strategy against the S&P 500, for example, analysts try to determine whether or not the stock market is relatively over- or undervalued by analyzing movements over short, or even longer term time frames.
S&P 500 price-to-book ratio
Similar to the P/E ratio, the price-to-book ratio is also a way to determine value. In this case, the S&P 500 P/B ratio is a comparison of the given stock index’s market capitalization to its actual book value — an accounting value that determines how much value a company can expect if it were to sell all of its assets on its balance sheet and cover any outstanding debt obligations. Often investors will use this value to find undervalued stocks with the hopes to benefit from its gains after its true value is realized.
To be sure, the S&P 500 P/B ratio measures the status of the 500 largest companies trading on the stock market today to determine whether they are as a group undervalued or overvalued. Market trackers such as SPX or SPY can be used to gauge these figures and determine the overall ratio.
Sector S&P 500 P/E ratios
Much like how the P/E ratio of a given stock works to determine how that individual company is valued — or against the broader S&P 500 with index trackers such as SPX or SPY — running this same ratio against individual sectors can provide some insight into stock market valuation, as well. For instance, sectors such as industrials, technology or energy can all be individually analyzed to measure whether they are over or undervalued from a price-to-earnings perspective. For technology, you’ll just need to find a broad sector fund to measure this, such as the SPDR® NYSE Technology ETF, Vanguard Information Technology ETF or Invesco S&P 500® Equal Weight Tech ETF, as an example.
When analyzing an individual company’s stock valuation, the debt-to-equity ratio is often used to determine a company’s financial leverage by factoring in its total liabilities in relation to shareholder equity.
To find this total, simply divide the company’s total liabilities by total shareholders’ equity. Investopedia uses Apple as an example: In a hypothetical scenario, let’s say the total company liabilities here were $241,000,000 and total shareholders’ equity is $134,000,000. The D/E ratio in this case would be 1.80, or $1.80 of debt for every dollar worth of equity.
Free cash flow
Another way to measure the value of a company is by factoring how much it pays to operate. Known as free cash flow, or FCF, this relatively simple datapoint can be used to do just that and is essentially the money that a given company has to repay its debt or the dividends and interest to investors. At its root, FCF equals a company’s sales revenue minus operating costs and taxes minus its required investments in operating capital.
The price/earnings-to-growth ratio, or PEG ratio, takes company value a step further by comparing both its P/E ratio to its total growth rate. You’ll have to look up the company’s P/E ratio for this one to get started, however once you have that number figured out, it’s just a matter of dividing by its earnings per share. The lower the PEG ratio, the more likely it is that the company in question is undervalued based on its future earnings expectations.
Yield curve inversion
At its most basic level, the yield curve depicts the difference in interest rates between Treasury bond yields. When plotted over a long period of time, the curve created when measuring a positive yield curve should result in short-term bonds carrying lower yields than long-term bonds. If rates are expected to fall or the stock market is expected to underperform in the near term, then longer-term bonds often come in higher demand, therefore delivering higher yields. When short-term bonds offer higher interest rates than long-term bonds, producing an inverted curve, then that may be a sign of a struggling economy.
All in all, there are dozens of ways to measure market valuation, all providing a different piece of the valuation puzzle. And while indeed most estimates today suggest that markets are overvalued, the bigger takeaway here is that future returns are not always tied to past performance — and that each measurement of valuation should be considered in context.
Whenever he presents a retirement projection to a client, Winter says both he and the client look at dozens of potential outcomes. However, because each possible scenario is based on a different assumption about future portfolio returns, the final decision is always made based on a client or investor’s risk tolerance. “The chance that U.S. stocks will generate the same returns going forward that they have in the past is very low,” he says, adding that “we can then focus on the more realistic retirement projection scenarios and set client expectations accordingly.”