Market Cap to GDP: A Fractional Decline in the Buffett Valuation Indicator
November 27, 2015
by Doug Short
Note: This update incorporates Wednesday's release of the Second Estimate of Q3 GDP.
Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment."
The four valuation indicators we track in our monthly valuation overview offer a long-term perspective of well over a century. The raw data for the "Buffett indicator" only goes back as far as the middle of the 20th century. Quarterly GDP dates from 1947, and the Fed's balance sheet has quarterly updates beginning in Q4 1951. With an acknowledgement of this abbreviated timeframe, let's take a look at the plain vanilla quarterly ratio with no effort to interpolate monthly data.
The strange numerator in the chart title, NCBEILQ027S, is the FRED designation for Line 41 in the B.103 balance sheet (Market Value of Equities Outstanding), available on the Federal Reserve website. Here is a link to a FRED version of the chart through Q2 of this year. Incidentally, the numerator is the same series used for a simple calculation of the Q Ratio valuation indicator.
The Latest Data
The denominator in the charts below now includes the Second Estimate of Q3 GDP. The latest numerator value is an extrapolation of the Fed's "Corporate Equities; Liability" using the Wilshire 5000 index quarterly growth. The indicator has been hovering just over 2 standard deviations above its mean. The current reading is 118.6%, down from 118.8% on the Advance Estimate. It is off its 126.8% interim high in Q1 of this year and a drop below the +2SD level after seven quarters at or above that benchmark.
Here is a more transparent alternate snapshot over a shorter timeframe using the Wilshire 5000 Full Cap Price Index divided by GDP. We've used the St. Louis Federal Reserve's FRED respository as the source for the stock index numerator (WILL5000PRFC). The Wilshire Index is a more intuitive broad metric of the market than the Fed's rather esoteric "Nonfinancial corporate business; corporate equities; liability, Level". This Buffett variant is off its interim high of Q2.
A quick technical note: To match the quarterly intervals of GDP, for the Wilshire data we've used the quarterly average of daily closes rather than quarterly closes (slightly smoothing the volatility).
How Well do the Two Views Match?
The first of the two charts above appears to show a significantly greater overvaluation. Here are the two versions side-by-side. The one on the left shows the latest valuation over two standard deviations (SD) above the mean. The other one is noticeably lower. Why does one look so much more expensive than the other?
One uses Fed data back to the middle of the last century for the numerator, the other uses the Wilshire 5000, the data for which only goes back to 1971. The Wilshire is the more familiar numerator, but the Fed data gives us a longer timeframe. And those early decades, when the ratio was substantially lower, have definitely impacted the mean and SDs.
To illustrate the point, here is an overlay of the two versions over the same timeframe. The one with the Fed numerator has a tad more upside volatility, but they're singing pretty much in harmony.
Incidentally, the Fed's estimate for Nonfinancial Corporate Business; Corporate Equities; Liability is the broader of the two numerators. The Wilshire 5000 currently consists of fewer than 4000 companies.
What Do These Charts Tell Us?
In a CNBC interview last year, Warren Buffett expressed his view that stocks aren't "too frothy". However, both the "Buffett Index" and the Wilshire 5000 variant suggest that today's market remains at lofty valuations — still above the housing-bubble peak in 2007, although off its interim high earlier this year.
Wouldn't GNP Give a More Accurate Picture?
That is a question we're often asked. Here is the same calculation with Gross National Product as the denominator; the two versions differ very little from their Gross Domestic Product counterparts. Note that GNP runs a month behind GDP, so these comparison charts are the first estimate for Q3.
Here is an overlay of the two GNP versions -- again, very similar.
Another question repeatedly asked is why we don't include the "Buffett Indicator" in the overlay of the four valuation indicators updated monthly. We've not included it for various reasons: The timeframe is so much shorter, the overlapping timeframe tells the same story, and the four-version overlay is about as visually "busy" as we're comfortable graphing.
One final comment: While this indicator is a general gauge of market valuation, it it's not useful for short-term market timing, as this overlay with the S&P 500 makes clear.