“The stock market is not the economy.” Such has been the “Siren’s Song” of investors over the last couple of years as valuation expansion has been the sole driver of the market’s performance. However, given that corporations derive their revenue from economic activity, the “Buffett Indicator” suggests investors may be walking into a trap.
Understanding the Buffett Indicator
Many investors are quick to dismiss any measure of “valuation.” The reasoning is if there is not an immediate correlation, the indicator is wrong. As I discussed previously in “Shiller’s CAPE – Is It Just B.S.”
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.
Such is incorrect. Valuation measures are simply just that – a measure of current valuation. More importantly, when valuations are excessive, it is a better measure of ‘investor psychology’ and a 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.
“Price is what you pay. Value is what you get.” – Warren Buffett
Such is what the Buffett Indicator tells us as it measures “Market Capitalization” to “GDP.” To understand the relative importance of the measure, we must understand the economic cycle.
The premise is that in an economy driven roughly 70% by consumption, individuals must produce to have a paycheck to consume. That consumption is where corporations derive their revenues and ultimately profits from. If something occurs, which leads to less production, the entire cycle reverses leading to an economic contraction.
The Historical Relationship
The example is simplistic, as many factors impact both the economy and markets short-term. However, there is a strong historical correlation between the market and the economy.
Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical. Such is particularly the case given the significant role spending has in the GDP equation. The chart shows the correlation between the two.
Given the historical data, the current “negative correlation” is quite an anomaly.
The Fed Impact
The break in the historical correlation has nothing to do with a change to market fundamentals. Instead, it is the Federal Reserve’s massive monetary interventions.
As Société Générale recently noted, the distortion of market pricing from the economy is quite astronomical.
“Using the bank’s equity risk premium framework on the impact of QE…understand how the different US equity indices have been impacted since 2009. There is a huge dispersion among the equity indices under review. The Nasdaq 100 has been the most impacted, even more so this year. The S&P 600 Small Caps, which has been the least impacted. As of Oct-2020, the Nasdaq 100 price level was 57% explained by QE.
Without QE the Nasdaq 100 should be closer to 5,000 than 11,000, while the S&P 500 should be closer to 1,800 rather than 3,300.”
The distortion of the financial markets by the Federal Reserve has created an illusion that the economy is doing exceedingly well when in reality it isn’t.
The Buffett Indicator
With this background, we now have a better understanding of what the “Buffett Indicator” represents as it measures “Market Capitalization” to “Gross Domestic Product.”