Warren Buffett's Favorite Market Indicator Shows the Stock Market Is Overvalued

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 (SNPINDEX: ^GSPC  ) are trading just below their all-time highs this afternoon. Many investors are wondering if this is still a good time to buy. By many measures, the stock market is overvalued. That assessment is backed up by one stock market indicator that Warren Buffett uses to determine whether the market is expensive or cheap. Read on to find out more.

Stock market today
While opinions vary, there have been many anecdotal signs lately that the stock market is overheated.

The average first-day pop of an IPO this year is 17%, the highest level in 10 years. New companies are being valued on fuzzy metrics. Twitter (NYSE: TWTR  ) is a good example, with its 73% first-day pop more focused on its user data than its advertiser data.

Corporate profit margins are at all-time highs, and earnings are not growing. The S&P 500 is rising on earnings-multiple expansion, rather than earnings growth, and it looks overvalued.

The cyclically adjusted P/E ratio (a.k.a. the Shiller P/E) is at 25 -- about 50% above its historical average of 16.5.

Respected investors including Jeremy Grantham, Wally Weitz, Donald Yacktman, Steven Romick, and Seth Klarman are building large cash positions. This indicates that they do not see opportunity in the marketplace currently and would rather be in cash to take advantage of future opportunities.

All the while the U.S. economy is growing slowly on the back of the Federal Reserve, which is pumping $85 billion a month into the market and now has a balance sheet of $4 trillion.

The question remains whether the market is undervalued, fairly valued, overvalued, or perhaps in a bubble. I've written before of why I think the stock market is overvalued, but let us turn to Warren Buffett.

Warren Buffett's favorite market metric
In two separate interviews in 1999 and 2001 Buffett explained to Fortune magazine's Carol Loomis that determining whether the market is expensive or cheap doesn't have to be complicated. The metric Buffett uses is:

The market value of all publicly traded securities as a percentage of the country's business -- that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

Basically, Buffett divides the total market capitalization of the U.S. stock market by gross national product, or GNP -- not to be confused with gross domestic product, or GDP. Gross national product measures the value of goods and services that a country's citizens produce regardless of where they live. This includes the value of goods and services that American companies produce abroad.

So how do you tell if the stock market is expensive? Buffett went on to explain: "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire."

Where is the stock market trading today?
One way to calculate the market value of all publicly traded securities is by adding the total market capitalization of the New York stock Exchange to the total market capitalization of the Nasdaq.

The market capitalization of the stock markets is reported monthly by the World Federation of Exchanges. At the end of October, the total market capitalization of U.S. markets was $22.9 trillion. The S&P 500 has risen 1.5% since then.

To find GNP, the Federal Reserve Bank of St. Louis has a great website where you can find most U.S. economic data. However, GNP is not reported until the second estimate of GDP, which comes out on Dec. 5. The most recent data for GDP for third-quarter 2013 is $16.86 trillion. GNP has averaged $250 billion more than GDP in the past six quarters, so we can project third-quarter 2013 GNP at $17.1 trillion.

Dividing the total market capitalization by GNP gives us a percentage of 134%. That is in the 94th percentile of results over the past 60 years and well above the 60-year average of 78%, indicating the market is overvalued.

Foolish bottom line
While I believe the stock market is overvalued, opinions differ.

Federal Reserve officials, including soon-to-be Chairwoman Janet Yellen and San Francisco Fed President John Williams, have said in the past two weeks that they do not believe the market is overvalued.

With the Federal Reserve committed to low interest rates and pumping money into the economy through quantitative easing, who knows how high the market can go. Predicting where the broad market will go in the short term is a game for fools (with a lowercase "F"). Stocks can always get more overvalued. When things get frothy, it's worthwhile to build up some cash on the side for when prices inevitably fall.

The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run.

Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.


Read/Post Comments (16) | Recommend This Article (38)

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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 November 21, 2013, at 3:58 PM, TomH wrote:

    Does the total capitalization of stocks that you quoted, $23 trillion, include the capitalization of ETFs? For example, SPY alone is about $157 billion, but including it in the total capitalization of the stock market would be double counting relative to GDP. This would skew your ratio relative to long term averages when ETFs did not exist.

  • Report this Comment On November 21, 2013, at 4:11 PM, TMFDanDzombak wrote:

    The total capitalization does not include ETFs.

    Full definition can be found here

    http://www.world-exchanges.org/statistics/statistics-definit...

  • Report this Comment On November 21, 2013, at 4:11 PM, TMFDanDzombak wrote:

    The domestic market capitalization of a stock exchange is the total number of issued shares of domestic companies (as defined in the number of listed companies definition), including their several classes, multiplied by their respective prices at a given time. This figure reflects the comprehensive value of the market at that time.

    The market capitalization figures include:

    - shares of listed domestic companies;

    - shares of foreign companies which are exclusively listed on an exchange, i.e. the foreign company is not listed on any other exchange

    - common and preferred shares of domestic companies

    - shares without voting rights

    The market capitalization figures exclude:

    - collective investment funds ;

    - rights, warrants, ETFs, convertible instruments ;

    - options, futures ;

    - foreign listed shares other than exclusively listed ones ;

    - companies whose only business goal is to hold shares of other listed companies, such as holding companies and investment companies, and regardless of their legal status;

    - companies admitted to trading (companies admitted to trading are companies whose shares are traded at the exchange but not listed at the exchange)

    The universe of domestic listed companies should be the basis of the domestic market capitalization.

  • Report this Comment On November 21, 2013, at 4:30 PM, georgebeshara wrote:

    Interesting article and quiet interesting metric. The $ 22.9 trillion does not include ETFs as per the definition. I think the market is relatively overvalued and we might see a correction from the current level. However, a bottom up strategy with focus on single digit PE multiples might pay-off on the long-term.

  • Report this Comment On November 21, 2013, at 9:19 PM, mortmain wrote:

    If you ask me, the dollar is completely overvalued. These people got a good deal....

  • Report this Comment On November 21, 2013, at 9:38 PM, Mathman6577 wrote:

    I believe Warren Buffett once said something to the effect of "if the stock market closed for ten years it wouldn't matter to me".

  • Report this Comment On November 22, 2013, at 4:49 PM, workhorseInvest wrote:

    Protip: Warren Buffett endorsed the [Market Cap]/[U.S. GNP] ratio 15 years ago. Since then, the growth in amount of profits that U.S. companies make overseas has increased dramatically: In fact, in 2011, a whopping 40% of U.S. annual profits were made overseas

    (http://online.wsj.com/news/articles/SB1000142412788732403480....

    So now think about the limitations of comparing market cap of stocks to the GNP of the UNITED STATES when about half of profits come from outside the U.S.

  • Report this Comment On November 23, 2013, at 12:13 PM, OutofFavor wrote:

    The graph in the article is not very actionable to an investor. Maybe it is illustrating that the two numbers generally move in the same direction, but otherwise, it appears the GNP line lags the S&P and you cannot estimate where the GNP is heading by it. So you'd better anticipate which direction we are heading before we get there in the reported numbers if you want to be successful.

  • Report this Comment On November 23, 2013, at 12:21 PM, bghouse wrote:

    So, if one chooses to assume that the the total market capitalization would inevitably fall to a 78% homeostasis, the answer would be to sell everything and buy Glenn Beck's gold.

    A world-is-sunny optimist might hope instead that the GDP would rise to the same point, and continue to put money in risky growth stocks.

    I think I'll just continue to put new money into stodgy dividend-paying stocks, and let my risky growth positions ride for awhile ...

  • Report this Comment On November 23, 2013, at 12:23 PM, Sotograndeman wrote:

    More importantly, Buffett was asked about the markets a couple of days ago, and he said he thinks they are "in a zone of reasonableness" and not stretched:

    http://www.cbsnews.com/8301-505268_162-57612947/warren-buffe...

  • Report this Comment On November 23, 2013, at 12:25 PM, Sotograndeman wrote:
  • Report this Comment On November 23, 2013, at 12:28 PM, veritasvincit wrote:

    @TMFDanDzombak,

    Thank you for this article.

    Thanks also for referring to opinions that vary from your assertion.

    As Sotograndeman states above, Buffett recently stated that stocks are in the "zone".

    Also, can you tell us how current 'book' values of stocks (use whichever index you prefer) affect how Fools should think about market valuations?

  • Report this Comment On November 23, 2013, at 1:13 PM, Sotograndeman wrote:

    veritas -- to be clear, I didn't say "in the zone" whatever that means.

    Precision of language is necessary here. To repeat Buffett thinks the markets are NOT stretched at present and are "in a zone of reasonableness".

    Howard Marks made similar comments in the past few days.

    Likewise David Tepper said on Bloomberg Friday that there's no bubble.

  • Report this Comment On November 23, 2013, at 2:07 PM, veritasvincit wrote:

    Sotograndeman,

    Yep, I wasn't clear; as I was typing my first comment, I was about to add the link to Buffett's CBS interview when your comment appeared above, so I made a poor reference to his "zone of reasonableness" remark.

    I don't think stocks in general are overpriced and would tend to use Buffett's opinion as a healthy guide to that. It seems to me that the attitude of investors purchasing bonds these days is unhealthy for them, and that someday they'll rush into stocks. I don't feel that the average retail investor has concluded that stocks were on sale a few years ago, and that he/she is inexplicably waiting for a further surge in the market to join in.

    Sorry to have clouded your reference to Buffett's recent interview.

  • Report this Comment On November 23, 2013, at 3:46 PM, marcjones281 wrote:

    The full version of the recent Buffett quote is:

    "I would say that they’re in a zone of reasonableness. Five years ago, I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced. Most of the time, they’re in an area where maybe they’re a little high, a little low, and nobody really knows exactly. They’re definitely not way overpriced. They’re definitely not way underpriced."

    Not stretched is different from "they're definitely not way overpriced"

  • Report this Comment On November 23, 2013, at 4:13 PM, Sotograndeman wrote:

    marc -- thanks, yes that is the full quote. The phrase "in a zone of reasonableness" is tantamount to saying not stretched up or down - especially together with "not way underpriced" and "not way overpriced".

    He used the term "not stretched" in another recent interview which I'll try to find.

    It's clear though, as David Einhorn said at the Robin Hood conference, that pockets of the market could be considered extended, as well as individual companies.

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