Buffett Indicator Says Markets Are Going to Crash?
The comments below are an edited and abridged synopsis of an article by Lance Roberts
“The Buffett Indicator says the stock market will crash,” read a message sent to Roberts recently. But, says Roberts, “I do not think it means what you think it means.”
The Buffett Indicator is a valuation that compares the stock market’s capitalization to GDP. It currently sits just shy of 2.44 times market-cap to GDP. That number doesn’t mean much on its own, but it’s striking when placed in a historical context. Even after the recent fall in markets, the ratio is still one of the highest on record, north of the 2.11 level recorded during the dot-com bubble of 2000, and considerably elevated compared to the average since 1950.
Since 2009, repeated monetary interventions and zero interest rate policies have led many investors to dismiss any measure of valuation. The reasoning is that, since there was no immediate correlation, the indicator is wrong.
The problem is that valuation models are not, and were never meant to be, market timing indicators. The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level, it means that the market is about to crash, and investors should be in 100% cash.
This is incorrect. Valuation measures are just that—a measure of current valuation. More important, when valuations are excessive, it is a better measure of investor psychology and the manifestation of the greater fool theory.
What valuations do provide is a reasonable estimate of long-term investment returns. It is logical that if you overpay for a stream of future cash flows today, your future return will be low.
Up for discussion: Why the Buffett Indicator is valuable; valuations and forward returns; and fundamentals don’t matter… until they do.