Warren Buffett is for some considered the best investor of all time. Among his many lessons and contributions to the world of finance, one that stands out is the Warren Buffett indicator. This indicator is a measure of valuation for the entire stock market relative to the size of the economy. But how is it calculated? Is Warren Buffett indicator trading strategy profitable?
In this article, we are going to look at what the Warren Buffett indicator is and backtest it to see the results.
What is the Warren Buffett Indicator?
The Warren Buffett Indicator is a financial metric that was popularized by Warren Buffett, one of the most successful investors of all time. This indicator is used to assess the overall valuation of the stock market relative to the size of the economy.
It is calculated by dividing the total market capitalization of all publicly traded stocks in a particular stock market by the gross domestic product (GDP) of the country to which the stock market belongs. The formula is as follows:
Warren Buffett Indicator = Total Market Capitalization / GDP
The idea behind this ratio is that it can provide insights into whether the stock market is overvalued or undervalued in relation to the broader economy. Warren Buffett has mentioned that this indicator is one of his preferred ways of assessing market valuations. He has stated that when the ratio is significantly higher than 100%, it may indicate that the stock market is overvalued, while a ratio below 100% could suggest that stocks are undervalued.
Investors and financial analysts use the Warren Buffett Indicator as one of many tools to gauge market conditions and make investment decisions. Although it should not be the sole factor in making investment decisions, it is worth seeing how the indicator performs on its own.
Why did Warren Buffett use this indicator?
On the eve of the new millennium, renowned investor Warren Buffett pondered the remarkable performance of the Dow Jones Industrial Average during the 17-year span from 1981 to 1998, considering it a stark contrast to the lackluster returns observed during the equally long period between 1964 and 1981. This discrepancy was particularly puzzling given the more favorable macroeconomic conditions that prevailed during the latter period, with economic output expanding at over twice the rate compared to the earlier one.
Buffett, in two Forbes interviews (Buffett and Loomis 1999, 2001), proposed that the market capitalization of equity (MVE) relative to gross domestic product (GDP), henceforth termed the MVE/GDP ratio, could have anticipated the superior returns of the 1981-1998 period. By signaling relatively lower valuations in the stock market, the MVE/GDP ratio, he argued, could have served as a reliable indicator of investment opportunities.
Despite Buffett’s assertion that the ratio of market capitalization to economic output represents “probably the best single measure of where valuations stand at any given moment,” its predictive power has received surprisingly limited academic scrutiny. Our research intends to address this gap in knowledge by delving into the efficacy of the MVE/GDP ratio as a predictor of stock market performance.”
How to measure total stock market value?
The easiest method to find the total stock market value is to look at the Wilshire 5000 index.
The Wilshire 5000 is the most common measure of the aggregate value of the US stock market. It is available from Wilshire directly, with monthly data starting in 1971 and daily measures beginning in 1980.
The Wilshire index was created such that a 1-point increase in the index corresponds to a $1 billion increase in US market cap. However, this ratio has drifted slightly over time, and as of 2020, a 1-point increase in the index corresponded to a $1.05 billion dollar increase.
The Warren Buffett Indicator Trading Strategy – backtest
A recent study conducted by Laurens Swinkels and Thomas Umlauft in 2022 called The Buffett Indicator: International Evidence, has addressed a gap in previous research by exploring whether the Buffett indicator can effectively predict international stock market returns. This study extends beyond the existing research, which has mainly focused on the United States.
Using data from fourteen developed markets dating back to 1973, the Buffett indicator proves to be a strong predictor of future equity returns, especially over longer timeframes, according to the study.
The following chart shows the Buffet indicator level and the subsequent 10-year annualized return. Note that as the indicator gets higher, the forward returns drop and vice versa (Source: Laurens Swinkels and Thomas Umlauft in 2022 called The Buffett Indicator: International Evidence):
Even when other popular valuation indicators like the CAPE ratio and mean-reversion are considered in the analysis, the Buffett indicator remains significant in predicting future returns. This suggests that its predictive power is not overshadowed by these alternative indicators.
The following chart illustrates the performance of a reference strategy from December 1985 to December 2019 compared to a benchmark. The strategy invests in the seven countries with the highest model-predictive ten-year forward returns from the data set.
When backtested, the strategy delivered an average annual return of 10.3%, while an equally weighted portfolio of the countries in the dataset returned 9.5%.
(Source: Laurens Swinkels and Thomas Umlauft in 2022 called The Buffett Indicator: International Evidence)
Importantly, these research findings have practical implications. A straightforward investment strategy that targets countries with the highest predicted returns based on this model shows statistically significant and economically meaningful returns compared to a simple buy-and-hold approach.
Additionally, this strategy experiences lower volatility and less severe drawdowns, making it an attractive option for investors. And even when factoring in transaction costs it still comes above buy and hold.
The Warren Buffett Indicator Trading Strategy – conclusion
In conclusion, today you learned what the Warren Buffett indicator is. We showed you a paper that backtested the indicator and found that it can predict future returns in the stock market quite powerfully.
Although it would be better to add other models or indicators to the strategy, the indicator ‘per se’ can be very helpful in determining the future returns of the stock market.
Criticisms and disadvantages of the Warren Buffett indicator
Let’s look at some factors that might indicate the indicator i poor, or even flawed:
No consideration of interest rates
The Buffett Indicator is considered a flawed measure of stock valuation by many because it doesn’t consider the impact of interest rates.
When interest rates are high, bonds become more attractive compared to stocks, pushing stock prices down. During the .com bubble, despite high interest rates, stocks were still overvalued due to investors’ reckless behavior. Today, with low interest rates, investors are forced to seek higher returns in stocks, artificially inflating the market.
The Buffett Indicator is flawed because it doesn’t account for the increasing internationalization of the stock market. While GDP only measures domestic economic activity, stock prices reflect the growing global reach of US companies. This disparity can artificially inflate the Buffett Indicator, making it less reliable as a valuation tool.
No consideration of international sales
Others argue the Buffett Indicator is flawed because it doesn’t account for the increasing internationalization of the stock market.
While GDP only measures domestic economic activity, stock prices reflect the growing global reach of US companies. This disparity can artificially inflate the Buffett Indicator, making it less reliable as a valuation tool.
GDP is not an appropriate measure
GDP is a quarterly measure of the total value of goods and services produced in the US economy. It is a backward-looking measure, reflecting past economic activity, and does not predict future economic performance. Also, the GDP might be “overflated” due to inflation.