Buffett's Favorite Indicator Is Wrong. Here's Why...

Amber Hestla's picture

Monday, August 27, 2018 - 12:00am

by Amber Hestla

There's a number of reports that Warren Buffett's favorite indicator is pointing to an overvalued market...

And yes, it's certainly true that Buffett said in a 2001 interview that he believed the ratio of the value of the stock market to GDP "is probably the best single measure of where valuations stand at any given moment."

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It's also true that this indicator shows a market that's overvalued. The chart below shows that the only time this indicator has been higher was in 2000, before the stock market crashed.

Source: Advisor Perspectives

But there are some problems with this analysis.

First of all, we are assuming that whatever Buffett says at any point in time is effectively carved in stone. I'm fairly certain his thinking evolves.

So, although he did say this was a useful indicator almost 20 years ago, we have no idea if he still believes it is.

My second objection to using this indicator is that it doesn't really jive with Buffett's actions regarding individual stocks. In fact, let's break down Buffett's "favorite" indicator and look at how it would actually apply to stocks.

Let's Use Apple As An Example
The numerator for the corporate-equities-to-GDP metric is essentially market capitalization, which is a statistic we can find for any stock. For example, Apple's market cap is about $1 trillion. (Earlier this month, the company notably became the first publicly traded U.S. stock to reach this milestone.)

GDP, the denominator in this ratio, is the total output of the economy. We could think of that as sales for a company, since sales are a measure of a company's output. Over the past 12 months, Apple's sales are about $255 billion.

Taking those two figures and applying it to our metric gives Apple a ratio of about 390%. Pretty overvalued.

But here's the kicker: Buffett has recently been buying Apple, which would indicate that he doesn't believe the stock is overvalued near current prices. In fact, a recent SEC filing shows that Berkshire Hathaway purchased an additional 12.4 million AAPL shares during the second quarter. Just a few months ago, the Oracle of Omaha told CNBC that he likes Apple stock so much, he'd "love to own 100% of it."

So, we can probably stop thinking of this as a useful indicator for individual stocks. And it's probably not overly useful for valuing the stock market either. And there's a big reason for that -- this type of analysis ignores potential growth.

It's All About Profits
Now, it is true that the stock market will take new innovations to the extreme. That happened in 2000 when investors talked themselves into believing the internet was going to change everything. And while the internet did change quite a bit, it did not change the fact that a company needs to be able to deliver profits.

Apple is worth $1 trillion because of its profitability, not because it delivers services on the internet. It's the profits that investors are valuing.

The next chart compares earnings to GDP.

Here, we see an upward trend that began in the 1990s. Coincidently, or maybe not, that is the time when GAAP (or "Generally Accepted Accounting Principles") rules for earnings started changing significantly.

I'm going to get a little technical to explain this point, so bear with me.

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Among the accounting changes was the requirement that companies write down the value of assets of companies they acquired when they become impaired. That rule was issued in 2001, and a number of companies were forced to write down acquisitions completed in the internet bubble.

Accounting rules require write-downs but do not allow for write-ups if the value of the assets increase, as they often do. This leads to higher profit margins. This also leads me to question why we should rely on something Warren Buffett said many years -- and many accounting rule changes -- ago.

I don't mean to question Buffett. But, if I could question him, I would focus my questions on the markets as they are now, not as they were years ago.

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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.