Warren Buffett doesn't label himself as an economist, but with the business and investing success he's had, he knows a thing or two about the economy. One tool that Buffett has become known for is an indicator that gives insight into whether the U.S. stock market is overvalued or undervalued.
The Buffett Indicator is the ratio of a country's total market capitalization of public companies to its gross domestic product (GDP). Simply put, it compares the value of a country's public companies to the total value of the goods and services the country produces in a year.
Calculating the Buffett Indicator is straightforward: You divide a country's total market cap by its GDP. If the number comes back over 100%, the stock market is seen as overvalued relative to economic output. On the other hand, a ratio under 100% could signal the stock market is undervalued.
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What the Buffett Indicator is saying about the U.S.
For the U.S., the Buffett Indicator is now 182%. As of July 2023, the total U.S. market cap (generally based on the Wilshire 5000 index) was $48.97 trillion, and annualized GDP was $26.91 trillion. The ratio fluctuates with the stock market, but 82% into overvalued territory by most standards is noteworthy.
Buffett himself said the indicator is "probably the best single measure of where valuations stand at any given moment." That doesn't mean it's foolproof, but it does mean it's worth paying attention to.
A ratio over 100% doesn't automatically signal danger. The U.S. has historically had a Buffett Indicator above 100%. It's more important to look at current levels relative to the Buffett Indicator for the U.S. for the past five to 10 years.
| Ending Period | Buffett Indicator |
|---|---|
| 2015 | 122% |
| 2016 | 123% |
| 2017 | 150% |
| 2018 | 135% |
| 2019 | 162% |
| 2020 | 195% |
| 2021 | 223% |
| 2022 | 164% |
| July 31, 2023 | 182% |
Data source: currentmarketvaluation.com.
From 2015 through the end of July, the average Buffett Indicator has been 161%, so 182% is definitely on the higher side.
Always look at the bigger picture
Considering its historical accuracy, the Buffett Indicator is a valuable tool for gauging market valuation. However, it's not the end-all for predicting market movements. Even if it does signal that a market correction or downturn is likely, that shouldn't deter investors. The indicator is useful but not infallible.
For long-term investors, market fluctuations -- both small and significant -- are inevitable. Reacting compulsively to market indicators (of any kind) can often do more harm than good. In this case, selling off assets in fear of a looming downturn could cause you to miss out on good gains and opportunities when the market rebounds. And if history is any indication, it's when it rebounds, not if it rebounds.
Stock market dynamics are influenced by many factors (often irrationally), and while it's important to be informed, it's equally important not to be swayed by short-term predictions or signals. Long-term investors should keep their eyes on the prize and not veer off course from their investment plans as long as those plans still align with their risk tolerance.
As Buffett once said, "The stock market is a device for transferring money from the impatient to the patient." Have patience and focus on consistency. You'll likely be glad you did down the road.
