What Is The Warren Buffett Indicator For 2023?

What is the Warren Buffett indicator? It’s a proxy for whether the stock market is overvalued, undervalued, or fairly valued and is a ratio that sums the total market capitalization of all stocks and divides it by GDP.

In a rational world, Buffett claims that the two numbers should be identical. So, when the market cap of all stocks is well below the economic output, the stock market is probably undervalued. And vice versa, the stock market is likely overvalued when the total market cap of all companies is greater than GDP.

Here in 2023, the Warren Buffett Indicator stands at 167.3%, suggesting the total market capitalization of all stocks is trading at a significant premium to the gross domestic product, or in other words, the stock market is very overvalued.

If the total market capitalization of all stocks in the US were to revert to a level equal to the GDP, investors could expect very modest gains of just 1.3% annually moving forward from the stock market.

History shows that when the Buffett Indicator ranges from 100% to 120%, the stock market is fairly valued. However, when it rises above 120% up to 145% it is in overvaluation territory. Above 145% is considered very overvalued.

Conversely, when the indicator sits in the 80%-100% range it suggests that the market is somewhat undervalued. Below 80%, the market is deemed very undervalued.

Is The US Stock Market Currently Overvalued?

According to the Buffett Indicator, the US stock market is overvalued. However, other measures of valuation should be factored in before making a final judgment on where stocks are headed.

One such measure is the price-to-earnings ratio of the S&P 500, which is deemed fairly valued when trading at a 20x multiple. Another way of interpreting that figure is to say that if you invested $1,000 today, you could get that $1,000 back in earnings over a 20 year period.

The S&P 500 is presently trading at a P/E multiple of 25.1x, suggesting it is considerably overvalued on an earnings multiple basis too.

The median P/E ratio for the S&P 500 is 14.94, also significantly lower than where the market sits today, as is the mean which is slightly higher at 16x

It should be noted that the P/E ratio is not always a perfect indicator of value. When an economy falters, earnings tumble and P/E ratios soar.

For example, in May 2009, the S&P 500 earnings multiple skyrocketed to 123x. That timeline also coincided with the year the market made a low following the 2008 housing and banking crises.

So, while it’s not a perfect indicator at all times, P/E multiples are a good benchmark most of the time, and currently the market does appear to be somewhat overvalued.

Will The Stock Market Fall?

Since Q1 2022, the Federal Reserve began hiking interest rates. They have done so at break-neck speed relative to history, increasing the Fed Funds Rate from 0-0.25% to 5.5% over the span of 18 months.

Warren Buffett has famously said that interest rates act like gravity on equity valuations and as they go higher so too does the force driving valuations lower grow. 

Another way of thinking about interest rates is like boat that must make headway against an oncoming wind. The higher the interest rates the more that gust of wind turns into a gale force hindering progress.

The reason interest rates rises are so challenging for companies is that most are indebted to some extent. At low interest rates, most Fortune 500 companies can borrow at lower rates than they can produce.

But as interest rates rise, the gap closes and, ultimately, all but the most successful and lowly levered firms, hit a brick wall where they can’t squeeze out much in the way of profits, if any at all.

When that time comes, earnings fall to zero, and the price-to-earnings multiple of the stock market rises considerably. Generally, analysts see the oncoming trend and anticipate lower prices by selling stocks, which in turn causes a domino effect where prices continue to fall. 

How Does The Stock Market Bounce Back After a Fall?

What turns the stock market around after a fall is generally optimism about the future that can be crystallized into one key metric, earnings growth.

When interest rates fall, and companies can squeeze out more profits to the bottom line because less capital is allocated to interest payments, investors often become more bullish on the prospects of equities over the medium-to-long term.

The faster earnings grow, the more Wall Street typically rewards a company with higher price targets. So too do institutional investors typically back a company that is growing profits and margins.

Where novice investors often fall short in assessing a company’s prospects, particularly a growth stock is by focusing on its top line while neglecting its profitability and margins. 

Ultimately, as Warren Buffett has famously stated, what matters most is cash flows. The valuation of a company is, simply put, the sum of its cash flows for all time discounted to present day.

In the real world, other factors influence prices and valuations, though, such as sentiment and day-to-day news events. As the Oracle of Omaha likes to say be greedy when others are fearful and be fearful when others are greedy.

That saying is a nod to sentiment and Mr. Market, who he describes as a temperamental fellow who shows up each day to offer you a price to buy shares.

Every trading day the price changes based on the whims of Mr. Market, but the nice thing is you don’t have to accept the price he offers on any given day.

Only when the deal seems really good, and the price is compelling is it worth taking the plunge and buying.

Is It Wise To Get Out of the Stock Market?

With the stock market seemingly overvalued based on the Warren Buffett Indicator and the S&P 500 price-to-earnings ratio, is it wise to get out of the stock market now?

Not necessarily because by exiting the market you are implicitly stating that you will know when to get back into the market again. History is rife with examples of active investors who underperform the general market indices because they attempt, but fail, to time the market well.

Unless you happen to be particularly skilled at entering and exiting the market in a timely fashion, it’s generally best to ride the whims of Mr Market as you would a rollercoaster ride because, over the long-term, the trend has been higher, even if the drawdowns are intermittently large. 

The Great Depression resulted in an astonishing 83% drawdown for the market, the largest on record. But other significant market corrections have occurred, including a 42.6% decline in the 1970s bear market, a 56.8% crash during the 2008 financial crisis, and most recently a 33.8% plunge in Q1 of 2020.

The challenge during these periods is to “hold on” because they don’t often last much longer than a year or two.

However, if you are entering a retirement period and worried about your life’s savings getting cut in half by a stock market correction, then a the traditional 60/40 allocation to stocks and bonds may make a lot of sense.

Is Warren Buffett’s Indicator Accurate?

It’s important to note that Buffett’s indicator is a guide more so than a pinpoint accurate gauge on where the market is headed.

For now, it suggests the market is substantially overvalued, and so the takeaway is, if we look to the next decade, returns are likely to be lower than they were in the past.

Equally, when the Indicator falls below 1, the reverse is generally true that returns from equities over the following decade will likely be higher.

Buffett has famously made these assertions at times of excess and drought, such as prior to the technology crash of 2000-02 when he assesses that equities appeared to be trading at inflated levels when factoring in inflation.

Similarly, almost a decade later, he made the claim that equities would outperform following the global financial crisis that resulted in over half the value of the market getting cut.

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