Buffett's Ratio Says Stocks Are Getting Interesting

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."

There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."

He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."

Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.

Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.

Source: Dow Jones, St. Louis Fed, author's calculations.

Understand what this does not mean:

  • It does not mean stocks are bound to go up in the short run. No metric can predict that.
  • It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.

And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.

But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:

U.S. Stocks as % of GNP

Average Subsequent 2-Year Return

< 60% 21%
60%-80% 24%
80%-100% 13%
> 100% (4%)

Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.

There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favor. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. In recent articles and discussions, fellow Fools have pointed out Waste Management (NYSE: WM  ) , Wells Fargo (NYSE: WFC  ) , Cisco (Nasdaq: CSCO  ) , EMC (NYSE: EMC  ) , and Costco (Nasdaq: COST  ) -- among others -- as opportunities we're excited about after the slump.

"The lower things go, the more I buy," Buffett said last week.

How about you?

Fool contributor Morgan Housel owns no shares mentioned above. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Costco Wholesale, EMC, and Waste Management. The Fool owns shares of and has created a bull call spread position on Cisco Systems. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Costco Wholesale, Waste Management, and Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 


Read/Post Comments (22) | Recommend This Article (59)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 15, 2011, at 5:59 PM, xetn wrote:

    This from the guy that believe everyone should pay higher taxes. I suggest the Buffett donate all his wealth to the IRS instead of giving it away to foreign countries with Bill Gates, etal.

  • Report this Comment On August 15, 2011, at 6:02 PM, TMFHousel wrote:
  • Report this Comment On August 15, 2011, at 7:01 PM, Bobjitsu wrote:

    xent, he doesn't believe everyone should be paying higher taxes. He has said he only believes the "mega-rich" should be paying them. Don't put words into his mouth no matter how much you may not like him.

  • Report this Comment On August 15, 2011, at 7:09 PM, prose976 wrote:

    Buffett is apparently unawares that he can unilaterally and voluntarily write a check any time. Is he afraid, or just show-boating? I'll bet it's the latter.

  • Report this Comment On August 15, 2011, at 7:15 PM, TMFHousel wrote:

    The number of people who come out and say "Buffett is free to write a check whenever he wants," and think they've made a clever point, is amazing.

    Folks, one person -- even the richest man in the world -- won't make a dent in the deficit. Taxes can't be voluntary. You have to get everyone involved. More here: http://en.wikipedia.org/wiki/Tragedy_of_the_commons

  • Report this Comment On August 15, 2011, at 7:48 PM, dstb wrote:

    "Folks, one person -- even the richest man in the world -- won't make a dent in the deficit. Taxes can't be voluntary. You have to get everyone involved."

    Exactly. Taxing the mega-rich more won't matter one bit. Our problem is one of spending so it should be reduced. Then the tax code should be rewritten so rates are lowered, deductions are minimized or eliminated, and EVERYONE pays something.

    Some of us just get tired of hearing guys like Buffett speak out about what other people should do so they can relieve their own guilt.

  • Report this Comment On August 15, 2011, at 8:17 PM, TimothyVR wrote:

    Enough about Buffett paying taxes. That is not the point of the article.

    I found it interesting and informative - and the sort of thing Motley fool does very well and is not found elsewhere very often. Thanks.

    I would like to see some articles about the long term secular bear market we are in. Just a thought.

    Tim

  • Report this Comment On August 15, 2011, at 8:20 PM, t0bes wrote:

    I don't suppose xetn or dstb bothered to read what Buffett actually wrote. Why bother with common sense like that when you can just churn out the usual tea-party nonsense

  • Report this Comment On August 15, 2011, at 8:38 PM, TruffelPig wrote:

    I am a buyer right now and have been since the S&P hit 1120 Aug. 8. I increased my portfolio by 40%. A lot of cash equivalents went. I am now at 50% stocks; 50% cash equivalents. The 50% just in case we hit 800 next spring or so. Buffet is correct, it is a buyers heaven and still is for many stocks (e.g., industrials are still cheap (IIVI, KAI), some fertilizer stocks (CF), some oils and oil drillers (SDRL, RES) etc. etc. - but every day they are getting more expensive again. I would not bet on the S&P going to 1100 again - maybe it is on the leg up to new hights actually when the economy improves globally in fall. Who knows? I don't.

  • Report this Comment On August 15, 2011, at 9:07 PM, MfromG wrote:

    The US goobermint is trillions of dollars in debt, no end in sight to the spending, the Euro zone is in deep crap and their Lehman Bros. moment is coming, might as well start buying stocks! Irrational exuberance.

  • Report this Comment On August 15, 2011, at 9:47 PM, mjmac89 wrote:

    TruffelPig,

    Can you point to some data that make you feel confident that the global economy will improve in the fall?

  • Report this Comment On August 15, 2011, at 10:15 PM, TimothyVR wrote:

    It's not irrational exuberance to buy KO or MCD or JNJ or IBM or PG at reasonable valuations. Their financial foundation and prospects look infinitely better than the US government.

  • Report this Comment On August 16, 2011, at 12:12 AM, Observero0 wrote:

    To TMFHousel :

    Agreed the contribution wouldn't make a dent, but you've missed the point of the exercise. It's called leadership (i.e., lead by example/walk the talk). Until I see such folks as Buffett leading by example (e.g., writing that check to the treasury &/or foregoing their tax exemptions/credits/deductions), I'll write off what he & other such folks say.

    =======================

    To Morgan Housel:

    Thanks for the article. Appreciate the info.

  • Report this Comment On August 16, 2011, at 3:21 AM, Stonewashed wrote:

    Well, the other possibility could be, WB is selling his book, while the gettin' is good..

  • Report this Comment On August 16, 2011, at 4:03 AM, lowmaple wrote:

    it won't do any good but i'llvent anyway. Buffett is right He obviously does not need book profits. As a businessman and investor before you assume guilt try giving allyour time an dmoney to help the stupid and poor before criticising Buffett........(spelt period).

  • Report this Comment On August 16, 2011, at 7:01 AM, marc5477 wrote:

    to xetn:

    Yes yes Buffet is an idiot and youre the genius. Keep voting your buffoons in. The last 2 Bushes did a splendid job of turning the world into a terrorist paradise and bringing the US to its knees without an ally in sight. But hey they made a lot of money for insurers, oil/energy tycoons, and they didnt take long to rescue their banking friends.

    Buffet, like him or not, at least cares enough about the US to put his money where his mouth is. He is willing to pay more to help the USA if it is legislated properly. This is what he is saying. Whether or not you think its fair is not important. The point is he is pro-america and loves the country while you just hate everyone but yourself and your fellow republicans. Everyone else isnt american to you.

  • Report this Comment On August 16, 2011, at 8:17 AM, Mliaom wrote:

    If you question Buffett's integrity and motives, you need serious help. He is as well respected as anyone in our history. I mean God is not going to send us an angels to give us an advice to relieve us from our foreign debt.

  • Report this Comment On August 16, 2011, at 8:46 AM, btukwh wrote:

    Does no one else notice the pattern of lower highs and lower lows since around 2000? I'm not a trending guy, but I did stay at a Holiday Inn Express last night. The pattern points to a much lower market coming.

    Really if you graph the S&P 500 over the last 30 years and chart the ttm p/e ratio beneath it you'll be startled. The two curves match. The increase in the stock market over that time isn't driven by increased earnings, but increased valuations. Scary stuff.

  • Report this Comment On August 16, 2011, at 10:57 AM, Googlemebaby wrote:

    Marc5477 could not be more correct with his opinion.

    It is frustrating and sad that the newly elected tea party members along with several republicans member refuse to work for the betterment of this nation. Instead, they will stop at nothing to see our president fail. How American is that? Warren Buffett is a true American hero in my opinion. He tells it like it is.

  • Report this Comment On August 16, 2011, at 11:53 AM, vettec5 wrote:

    Yes, those awful tea party members. They question business as usual in Washington and call for less government spending. Those crazy radicals!

  • Report this Comment On August 19, 2011, at 3:37 PM, muddlinthrough wrote:

    @btukwh,

    So, what you're saying is, 'It's not the economy, it's inflation, stupid?'

    I'm not convinced of anything other than when I have 'stuff,' such as money in the bank, I feel relief, and when I am trying to acquire or dispose of 'stuff,' I feel stress.

    As to whether or not Buffet is a genius or an average guy is not for debate. The very rich, as Fitzgerald observed, are not like you and me. For one thing, I plan on outliving Gates & Buffett...although Gates isn't that much older than I am.

    I won't die with nearly as many 'markers' of wealth, but unless things go sideways, very sideways, I also think they won't be in that much more comfort or pain than I will when any of us kicks the bucket.

    My point? Yes, this site is devoted to wealth accumulation through intelligent stock picking. Buffett has done extremely well, first by being in the right place at the right time, then just by continuing to exist and not screw it up badly.

    His methods are different than your methods. But unless you're buying at the scales he's buying in, or at a 'preferred purchasing position' such as he is, then using his methods is sort of like a car driver deciding they should use the same criteria that an M1 Abram's tank commander will.

    Sure, 'put it in drive' are the basics. But after that, there's not much parallel.

  • Report this Comment On September 16, 2011, at 5:42 PM, Ruhaan wrote:

    Morgan -

    Great article. Always appreciate your indepth analysis. Could you please run through the exact calculation number about how you calculate this and give an example for 2009 and 2010 with source of your info. I would really appreciate that.

    Thanks -

    Ruhaan

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1539324, ~/Articles/ArticleHandler.aspx, 12/19/2014 6:37:37 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement