Fifteen years ago, Warren Buffett revealed to Fortune magazine that the market cap-to-GNP ratio is his favorite indicator to determine whether the stock market is expensive or cheap. By that, Buffett meant the market cap of the entire stock market divided by the total gross national product of the country. While many people instead use the market cap-to-GDP ratio because gross domestic product is updated a month before GNP, the result is roughly the same. And right now, the metric suggests that the stock market is overvalued.
Should investors expect low returns over the next few years? Read on to learn more.
Warren Buffett's market indicator
So how can the market cap-to-GNP ratio tell you whether the stock market is expensive? Buffett explained: "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 $27.86 trillion. The S&P 500 has been essentially flat since then.
To find GNP, the Federal Reserve Bank of St. Louis has a website where you can view most U.S. economic data. However, GNP is not reported until the second estimate of quarterly GDP is released -- which will happen next on Nov. 25. The most recent data for third-quarter GDP is $17.535 trillion. Gross national product has averaged $225 billion more than GDP over the past four quarters, so we shall assume Q4 2013 GNP is $17.76 trillion.
Dividing the total market capitalization by projected GNP gives us a percentage of 157%, which indicates that the market is overvalued.
There are also many anecdotal signs that the stock market is overheated:
- Respected investors including Jeremy Grantham, Wally Weitz, Donald Yacktman, Steven Romick, and Seth Klarman are holding large cash positions.
- Buffett is sitting on his largest cash pile ever, with $60 billion in cash and equivalents on Berkshire's Hathaway's balance sheet. Buffett is known for stockpiling cash until irresistible investment opportunities present themselves.
- Warren Buffett's partner, Charlie Munger, said in September that he has not bought a stock in his personal accounts in two years.
- The biggest IPO in history occurred in September, with Alibaba (NYSE:BABA) raising $25 billion. The stock is up nearly 70% since then.
- The cyclically adjusted P/E ratio (i.e., the Shiller P/E, or CAPE) is at 26.65 -- a full 61% above its historical average of 16.56.
Meanwhile, economies around the world, both emerging and developed, are growing slowly.
While I believe the stock market is overvalued, opinions differ.
The best investors don't invest in the market; they buy great companies at good prices. While it's getting harder and harder to find those, doing the research now will enable you to take action when opportunities arise.