The “Buffett Indicator” is the ratio of total US stock market capitalization to US Gross Domestic Product (GDP). Named after Warren Buffett, the “Oracle of Omaha” once called this ratio “the best single measure of where valuations stand at any given moment.” According to Buffett and the indicator, values above 100% signal overvaluation for US equities. But how effectively can the “Buffett Indicator” be used to predict stock market downturns?
In our latest white paper, Which Leading Indicators Best Predict Market Declines?, we examined the “Buffett Indicator”, inverted yield spreads, and five other leading indicators commonly used to predict market and economic cycles. Over 21 major market declines since 1950, each indicator’s accuracy and consistency were varied. Each indicator’s correlation with forward S&P 500 returns, and how much of a warning, measured in months, the indicators gave for impending market crashes were also investigated.
The findings help answer a timeless (and timely) question: can any leading indicator be consistently trusted to stay ahead of market declines
How Accurate is the “Buffett Indicator” at Predicting Market Declines, Historically Speaking?
Out of a possible 14 major market declines (10% or greater) dating back to 1971, the “Buffett Indicator” provided advance warning to 7 of those downturns. Though anything above a 1:1 ratio—or level of 100%—is considered a sign of an overvalued market, we increased the overvaluation threshold by 20% to establish a critical level which would be hard for advisors and investors to ignore.
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A success rate of just 50% places the “Buffett Indicator” among the most reliable of the seven indicators studied. However, there’s a catch. The “Buffett Indicator” has been above 120% since Q3 2016, meaning that stocks have been overvalued for about six years according to the metric. On average, the “Buffett Indicator” first entered overvaluation territory 24.2 months in advance of those seven major market declines.
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How Does the “Buffett Indicator” Hold Up in Modern Equity Market Dynamics?
To evaluate how the “Buffett Indicator” has performed in recent history, we examined its average level since 2000 of 110.6% and applied a 20% handicap to arrive at a “hard-to-ignore” overvaluation threshold of 132.7%. Of 7 major market declines since 2000, this updated “Buffett Indicator” signaled warnings for 4 of them.
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The indicator provided more “well-timed” warnings of market declines using this elevated threshold. The average time from initial overvaluation signal to relative S&P 500 peak using the updated threshold was about 13 months shorter, down to 10 months. And each warning sign was distinct, with no single overvaluation signal preceding more than one major market decline.
A downside to following the elevated “Buffet Indicator” threshold: not receiving any warning for the 2007-09, 2015-16, and early 2018 market declines.
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This article was originally published on YCharts.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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