Supposedly a favorite metric of Warren Buffett for sensing value or froth in the stock market is the ratio of stock market capitalization to gross domestic product. That is why the ratio has come to be known as the “Buffett Indicator.” If you were to google “Buffett Indicator,” you will see that there are about 440,000 results and most of them are likely to be articles or posts pitching doom & gloom about the stock market. This is hardly surprising given that the ratio (about 150% as of the end of 2014) has recently surpassed the prior 2007 peak (though it’s well short of the 2000 all-time peak), and we all know what happened in 2008.
However, my purpose here is not to dispute the Buffett Indicator’s utility as a measurement of stock market overvaluation. Rather, I aim to consider whether it is actionable data, and whether the metric has actually been useful to investors.
First of all, gathering accurate data for this post is a bit tricky, but luckily the World Bank has a pretty good index of market capitalization as a percentage of GDP for many countries. Using this data, I went back to the end of 2007 (the prior cycle’s peak), and I took a sampling of five of the “cheaper” markets (meaning they had among the lowest market cap to GDP ratios), and five of the more expensive markets.
Here are the ten markets I considered (“cheap” markets on top; “expensive” markets below):
Using this data, I thought it would be interesting to see how the various markets have performed since then using the respective country ETFs for each market. The results were as follows:
Now, before I get into my conclusions, I would say that of course the results might be different if measured in local currency, but that’s not an option most US investors have. I will also admit that this is a relatively small sample size.
With that being said, I think it is somewhat informative that the markets with the lower market cap to GDP ratio underperformed the more expensive markets. Given the various issues each of those countries has faced since 2007 (Brazil’s economic crisis and global commodity collapse; France and Germany in the midst of the Eurozone crisis, etc), their relative cheapness didn’t spare them underperformance.
Furthermore, excluding an “expensive” market like Switzerland from your portfolio would have cost you as it has been one of the best global performers for a fairly long time even though it has had an elevated market cap to GDP ratio for many years. It of course makes sense that the market capitalization of Swiss companies would dwarf its GDP; Switzerland is very business-friendly, and companies domicile there, even though they do a great deal of their business outside the country.
The point I am trying to make is that while a metric like the “Buffett Indicator” might be useful as an indicator of market over- or undervaluation, it is of little use in isolation because it fails to take into account many other variables that play parts in long-term market performance. In an era of increased globalization when almost half of S&P 500 revenues come from overseas, investors are better off worrying about other things if they insist on worrying at all.