Buffett Indicator: Is the U.S. Stock Market in a Bubble?

What is the Buffett Indicator?

Given the current concerns about a potential AI bubble and a possible stock market peak, I've chosen to begin the “Investor Essentials” category with a discussion of the Buffett Indicator. While many of you may be familiar with it, let me briefly summarize the Buffett Indicator for those who are not.

Warren Buffett mentioned the Buffett Indicator in an interview with Fortune in 2001. The Buffett Indicator is a ratio that divides a country's total stock market capitalization by its Gross Domestic Product (GDP). It is used as a measure to evaluate the stock market's value relative to the size of the economy. Generally, a Buffett Indicator below 70-80% is considered an undervaluation, while over 120% is often seen as an overheated market.

Current Buffett Indicator for the U.S.

So, what is the current Buffett Indicator level for the U.S.?

Source: www.currentmarketvaluation.com

Since GDP is reported quarterly, the most recent Buffett Indicator, as of June 30, 2024, is 202%. Aside from the surge in 2021 due to the massive injection of liquidity during the covid-19 crisis, this is the highest level ever. The long-term trend line of the Buffett Indicator is upward-sloping, indicating that over time, the Buffett Indicator itself tends to rise. Even taking this into account, the current Buffett Indicator is 63% above the trend line.

What If It Converges to the Long-Term Trend Line?

If the index converges to the long-term trend line one year from now, what might happen to stock prices? Two simple assumptions are made: (i) overall current stock price to be maintained, (ii) annual GDP growth of 2%

• (Current Indicator 163) x (Current GDP 100 / GDP in 1yr 102) = c. 160
• (LT trend line 100 - Indicator 160) / (Indicator 160) = -38%

With this calculation (together with assumptions), one could interpret that the stock market might decline by about 38% in a year. Typically, such a significant drop in stock prices would occur during a severe economic recession, so assuming 2% GDP growth seems optimistic. However, some might think the gradual upward slope of the long-term trend line could offset this. In summary, if we (fearfully) assume the Buffett Indicator converges to the long-term trend line, U.S. stock prices could drop by around 40% in one year.

I’m curious to compare the Buffett Indicator peaks right before the dot-com bubble, the global financial crisis, and the covid bubble collapses. You can find that the current Buffett Indicator is higher than that of dot-com bubble and global financial crisis but very slightly lower than covid-19 bubble in 2021.

• Dot-com bubble in 2000: roughly 150%
• Global financial crisis in 2008: roughly 110%
• Covid-19 bubble in 2021: roughly 200%

What Is Warren Buffett Doing About It?

How does the person who created the Buffett Indicator see the current market? Warren Buffett’s company, Berkshire Hathaway, which manages around $1.1 trillion, reduced its stock allocation to about 50% of its total assets as of June 2024. Instead, it dramatically increased its cash and cash equivalents to 47%. The remaining 3% is in long-term bonds (U.S. Treasuries with less than one year to maturity are considered cash equivalents). You’ve probably read the news that Buffett sold half of his Apple stock position. Actually, it’s more than half because Berkshire sold about 390 million Apple shares in the second quarter on top of 115 million sold from the first quarter, leaving about 400 million Apple shares. 

Berkshire's cash stake grew to $277 billion as of June 30 from $189 billion three months earlier. It now holds more short-term U.S. Treasuries than the Federal Reserve. Based on his actual actions, it seems Buffett believes the stock market is overheated, regardless of what he says publicly.

Weakness of the Buffett Indicator

However, the Buffett Indicator has its weaknesses. Let me mention two notable ones. First, while stock prices reflect global revenues and profits, GDP only includes domestic corporate activities. For instance, Amazon’s business in India is not included in U.S. GDP. As the world becomes more globalized and U.S. companies expand their overseas operations, the Buffett Indicator might rise. (One could argue that foreign companies operating in the U.S., included in the U.S. GDP, offset U.S. companies' overseas activities.) However, this is somewhat accounted for by the upward slope of the long-term trend line in the Buffett Indicator.

Second, the Buffett Indicator does not take into consideration interest rates and inflation, which have significant impacts on the economy. Additionally, the Buffett Indicator doesn’t consider factors such as new technologies, productivity, and growth rates that influence stock prices. These are important limitations, so how to interpret the Buffett Indicator is up to you.

How About Other Stock Markets?

Before wrapping up, shall we also check the Buffett Indicators for the second and the third largest economy in the world?

⦿ Buffett Indicator: China 43 as of September 2024

Source: https://en.macromicro.me

⦿ Buffett Indicator: Japan 160 as of September 2024

Source: https://en.macromicro.me

One might compare the Buffett Indicator of the U.S. with that of China and conclude that the U.S. stock market is inflated. Alternatively, they may believe that Japan’s stock market has a 40 percentage point upside if it matches the U.S. However, I believe that one shouldn't compare the Buffett Indicator of one country with that of another, as each country has a different industry structure, stock market capitalization, growth prospects, and so on. Instead, the Buffett Indicator of a country should be compared to its own historical levels to assess potential overvaluation or undervaluation relative to the past.  So, do you think the stock market of China or Japan is overvalued or undervalued? I'll leave that with you as food for thought.

Thanks for reading. I wish you success in making smart investments!

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