Description

The Buffet Indicator is the ratio of the United States stock market value to Gross Domestic Product. When the ratio is greater than 1, it indicates that the stock market value is anticipating future returns to be greater than current GDP. The value is similar to a price to earnings ratio, simply on a national scale. Given GDP annual growth typically falls in the 2%-3% range, a value much greater than 1 suggests the market could be overpriced.

There are a variety of reasons the ratio could be significantly larger than 1. In particular, GDP does not measure international productivity while the stock market does. For large U.S. companies like Apple or Amazon, a significant portion of their earnings come from international sales, thus making GDP underestimate the actual value of productivity for U.S. companies. Interest rates impact stock valuations. When rates are low, stock valuations typically increase because alternative, lower risk assets like bonds yield less. When rates are high, the opposite is true.

Regardless of these limitations, the indicator is a crude measure that can be incorporated into a broader risk assessment framework investors can use to understand the current state of the markets.

Data Sources

• U.S. GDP from Federal Reserve Economic Database (FRED)
• Wilshire 5000 values from Yahoo Finance