“Buffett Indicator” at record levels. Are there any reasons for concern

The “Buffett Indicator” is a measure of the value of all publicly traded companies in a country and is the ratio of the stock market’s market capitalization to gross domestic product (GDP). Unofficially, he bears the name of a famous investor, since it was Buffett who more than once called him the best indicator of stock market valuation.

The indicator shows whether a country’s stock market is overvalued or undervalued compared to its historical average. In fact, this is the P / S multiplier for the entire country.

The most common way to assess the value of the US stock market is the Wilshire 5000 Index, which consists of more than 3,500 US stocks. GDP is the total market value of goods and services produced within a country.

On Friday, the Wilshire 5000 Index rose to $ 41.899 trillion, while Q4 2020 GDP is $ 21.5 trillion. Dividing those numbers, we get Buffett’s indicator at 195%, well above the 159.2% hit just before the 2000 dot-com crash.

According to the theory, the indicator value from 115% to 136% indicates a moderate revaluation of the stock market, more than 136% – a significant one and is a harbinger of a stock market crash.

Why the Buffett indicator doesn’t always work

The main disadvantage of the Buffett indicator is that it does not take into account the state of the treasury bond marketexpressed in rates of return. Treasury bonds represent a risk-free asset as an alternative to the stock market and correlates directly with it.

When interest rates are high or rising, stocks fall. If interest rates are low or falling, stocks go up.

Over the past 50 years, the average yield on the benchmark 10-year US Treasury bond has been 6%. Even during the peak of the dot-com bubble, when the Buffett indicator hit an all-time high of 159.2%, the yield on the 10-year bond was 6.5%.

Today, the Buffett Indicator is about the same number of points above its historical average as it was during the dot-com bubble, but bond yields are at record low level: 1.215%. In other words, during the 2000 bubble, investors had a good opportunity to move out of stocks into bonds, which at the time were offering good returns.

However, today bond yields do not even cover inflation. In the absence of alternatives, investors invest in riskier assets, which leads to stock market growth.

Despite the high Buffett score, the stock market may have reasons stay high as long as interest rates are too low.

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