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Mark Hulbert

Mark Hulbert

March 2, 2021, 9:07 a.m. EST

Even a modified ‘Buffett Indicator’ is more bearish than ever

By Mark Hulbert

Could it be that Warren Buffett hasn’t been paying attention to the so-called Buffett Indicator, which is the ratio of U.S. stock market cap to GDP?

Some are wondering about this in light of what Buffett did (and did not) say in his annual letter to Berkshire Hathaway (NYS:BRK.A) (NYS:BRK.B) shareholders that was released on Feb. 27. Many , including me , were expecting him to at least acknowledge the stock market’s overvaluation. But he was uncharacteristically silent.

The Buffett Indicator currently is at its most extreme bearish level in U.S. market history, and several decades ago Buffett described it as “the best single measure of where valuations stand at any given moment.”

Yet since Buffett didn’t mention this indicator in his shareholder letter, and he did not respond to a request for comment, we don’t know what he thinks about it and stock market valuation generally. Investors may have to wait until Berkshire’s annual shareholder meeting, scheduled for May 1, to ask the question directly.

Meanwhile, commentators have proposed two ways in which they think the Buffett Indicator needs to be modified to make it relevant to the current market. Both of these tell a less-bearish story, and for this column I will analyze whether there is any reason to given them more weight.

Modification #1: Focusing on potential GDP rather than actual

The first modification is to make the denominator of the ratio “potential” GDP rather than actual. The rationale is that, because the U.S. economy was put into a medically induced coma in response to the COVID-19 pandemic, the latest GDP numbers are artificially low, which in turn makes the Buffett Indicator artificially high — and bearish. In other words, since equity valuations are a function of companies’ long-term earning potential, focusing on actual GDP paints a misleading portrait.

To test this rationale, I turned to the estimates of “potential GDP” that are calculated by the Congressional Budget Office (CBO) . “Potential GDP” is defined as the “country’s maximum sustainable output” — how big the U.S. economy could become without leading to inflation. Though the CBO expresses no opinion on whether the economy will in fact expand to equal its potential, its estimates enable us to calculate the lowest theoretical level for the Buffett Indicator given where the stock market currently stands.

Unfortunately for the bulls, this modification makes precious little difference to the predictions of the Buffett Indicator. Though the modified ratio based on potential GDP is 3.1% lower than the original version, it still is higher than at any other time over the past 70 years (which is how far back data extend). Notably, even the modified Buffett Indicator is 24% higher than what the original version was at the top of the internet bubble in 2000.

Modification #2: Focusing on a global rather than U.S.-only Buffett Indicator

The second proposed modification is to focus on a global Buffett Indicator. The rationale is that U.S. companies derive an increasingly large proportion of their value from overseas operations. If we focus just on the U.S., therefore, the indicator will be artificially high — and bearish. Currently, for example, the ratio of global stock market cap to total global GDP is around 1.13, versus 1.92 for the U.S.-only version.

Unfortunately, this global version of the Buffett Indicator also fails to improve on the predictive abilities of the U.S.-only version. I was able to obtain data for this global version back to the early 1980s, allowing me to test both versions in head-to-head tests over the four decades since then. I measured the ability of each to predict the S&P 500’s (S&P:SPX) inflation- and dividend-adjusted return over the subsequent 5- and 10 year periods. The original version came out ahead.

Another significant data point: The global version of the Buffett Indicator has a better track record in the first half of my sample than in the second half. That’s at odds with the narrative that, because U.S. corporations have had a growing overseas presence, the global Buffett Indicator is a superior indicator.

The bottom line? It’s hard to wriggle out from underneath the bearish message of the Buffett Indicator. Berkshire Hathaway shareholders should start preparing their questions now for the May 1 shareholder meeting.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com .

More: What’s Missing from Warren Buffett’s annual letter

Plus: Charlie Munger says it’s ‘really stupid to have a culture which encourages [so] much gambling in stocks’

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