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The Buffett Indicator Is Fatally Flawed And Kept Followers From Enjoying The Bull Market – SPDR S&P 500 Trust ETF (NYSEARCA:SPY)


Introduction to the Buffett Indicator

The Buffett Indicator is a widely used indicator for the valuation of US stocks, especially the S&P 500 index. In a 2001 interview with Fortune, Buffett stated that Still, it is probably the best single measure of where valuations stand at any given moment.”

The indicator compares the “Corporate Equities; Liability” series from the Fed’s Z1 data, the numerator, against the US GDP, the denominator.

The idea is that when the ratio gets high, it indicates the valuation of US stocks is too high relative to the economy, and future returns will be dismal, and vice versa.

As a result of the seemingly reasonable and objective economic comparison, the indicator has become very popular, especially since it has received Warren Buffett’s blessing. Many market analysts compare the current level of the indicator to the long-term mean to make judgments about the market.

However, for any time series, comparisons to long-term means should only be made if there is no expectation in a shift of mean over time, and if there is a shift, then comparisons will be very misleading.

The Buffett Indicator overstates valuations in recent decades since it doesn’t capture global GDP

The flaw with this indicator is that the denominator and numerator are not consistent over the entire time series, and therefore, the mean ratio will be expected to shift over time. The numerator is the market valuation of US equities, but US equities do a substantial share of their business overseas, which is not captured in US GDP. As of 2016, the share of total S&P 500 sales from overseas was 43%, and it had been as high as 48% in 2014. So the numerator reflects overseas profits, since the US stocks are valued based on total profits, some of which occur overseas, but the GDP is only US GDP, which only reflects US business.

If US GDP and World GDP were growing at the same rate, this would not be problematic, however, in the last few decades, global GDP has grown much faster than US GDP, so it is no surprise that US stocks’ profits and market valuations can grow faster than US GDP, since they have exposure to the faster-growing Global GDP.

This phenomenon will cause the Buffett Indicator reading to rise over time, all else equal. Since the share of US companies’ profits from overseas markets has increased, while the global GDP has been rising faster than US GDP, one would expect the indicator’s mean to shift, and actually increase over time. Therefore, the shift and expected increase in indicator’s mean over time, causes some conclusions of overvaluation to be less valid.

An adjusted view of the Buffett Indicator

The indicator is certainly reasonable as long as it compares like-to-like. The regularly used indicator compares US Stocks with only US GDP, where the former has earnings from all over the world, but the latter only reflects US business activity.

I propose an alternative, the “Sovereign Investment Insight Ratio,” or SII ratio. This ratio would adjust the GDP to be reflective of the GDP commensurate with where the earnings for US stocks occur.

Process:

  1. I pulled historical World GDP from the World Bank.
  2. I pulled US GDP data from FRED, and the Market Cap data for US Equities also from FRED.
  3. Subtract US GDP from global GDP for each year to get “non-US” or foreign GDP.
  4. Impose the 43% share of foreign revenue (assumed to be profits as well), on the mix of US GDP vs. non-US GDP. This will give us the “pertinent” GDP for US companies, on a historical basis, reflecting the current mix. If the mix changed over time, then the comparison could be invalidated. So the historical “pertinent GDP” series is a weighted average of 43% to non-US GDP, and 57% to US GDP.
  5. Take the ratio of US equities market cap to “pertinent” GDP.
  6. Then index this to a historical value, here 1960, so comparisons can be made to the raw Buffett Indicator (also indexed to same year), since the levels of the two series are different.

Below is a screenshot of the data work in excel used to generate the series:

Below is the comparison of indexed (to 1960) values of the SII indicator to the Buffett Indicator:

As we can see, the SII indicator shows the valuations are a much less severe level of overvaluation than the raw Buffett Indicator. The data here goes through Year-End 2016, so using the Buffett Indicator, a strong sell would have been issued for US Stocks, and one would have missed the big 20% rally in the S&P 500 price index for 2017, but if one used the SII indicator, there was no signal of such alarm. I have discarded the Buffett metric as a valid valuation indicator a while ago, and accordingly, I did enjoy the rally in 2017 as I was very bullish coming into 2017.

Also not reflected here is the impact of tax reform. As corporate tax rates are cut to the lowest levels in many decades, it would only be natural to expect the valuations of stocks rise as a share of GDP, since the earnings as a percent of GDP may rise as well. Even though tax cuts haven’t been implemented yet in this data, the expectation of this change for 2018 and forward should serve to elevate the SII and Buffet Ratios above their long-term averages which reflected greater historical average tax rate.

Conclusion

The Buffett Indicator is a good indicator, in theory, to gauge the relative valuation of US stocks. However, it is distorted by the fact that the US equity market capitalization, the numerator, reflects all global business, but the denominator, US GDP, only reflects US business. This becomes problematic, when global GDP has consistently grown faster than US GDP for the last few decades.

This issue harms the relevancy of the Buffett Indicator, so to adjust, I propose an alternative, SII Indicator which adjusts the “pertinent GDP” to reflect the current mix of US and non-US GDP.

The Buffett Indicator signaled gross overvaluation going into 2017, keeping many investors out of US stocks, while the SII indicator doesn’t have nearly as ominous of a prognosis. As of year-end 2016, the Buffett Indicator had a reading only 11% below the 2000 level, when many agree the stock market was in a bubble in 2000.

Being only 11% within bubble valuations is very alarming. However, the SII indicator shows 2016 being 28% below the level reaching for the same index in 2000, which shows much less cause for concern, especially when corporate tax cuts were coming down the pipe, and should serve to boost the expected average of the ratio as corporate profits would likely rise as a share of GDP.

It is dangerous to use indicators that have shifts in expected means over time, because they can give misleading indications. The same issue is present for the Shiller PE, which overstates the overvaluation of the stock market since comparisons to long-term averages miss the impact of buybacks, which are a recent phenomenon. I’ve also covered this issue in a previous article.

Many investors have missed the upside in the market because of relying on faulty indicators that likely need to be adjusted. Many bears cite the Buffett Indicator and Shiller PE both of which give misleading indications. Others cite the sharp rally in 2017 as being indicative of a bubble, when forward P/E ratios have not even risen since a year ago, as I’ve noted.

No, this is not saying “This time it’s different”

I suggest discarding metrics such as the Buffett Indicator, (and also Shiller PE) if it is not adjusted properly for significant distortions when comparing recent readings to longer-term averages. Some critical bears will insist I am merely saying “this time it’s different,” and irrationally justifying high market valuations.

This criticism seems off-base, since I am not dismissing the economically rational comparison of the stock market capitalization to GDP; in fact, I endorse the comparison. My criticism is of a metric, such as the Buffett Indicator, which no longer does the comparison on a like-to-like basis, where I believe the SII indicator does a better job.

After reviewing the SII indicator, I admit the stock market valuation is not cheap by any means, but given interest rates, and the Yield Curve indicating plenty of time until the next recession, I continue to hold the SPDR S&P 500 ETF Trust (SPY), albeit with much less enthusiasm for future returns than a year ago.

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Have a Prosperous 2018!

Additional Disclosure: The information contained in this article is an opinion and constitutes neither actionable investment advice nor a recommendation to trade any security.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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