Thursday, July 24, 2014

Buffet's "Bubble Red" Indicator

You may have noticed a recent post on Zero Hedge ("Forget Shiller's CAPE, Warren Buffet's 'Best Indicator' Is Flashing Bubble Red"). It includes a chart that shows the market value of U.S. companies as a % of nominal GDP, and it does look scary: by this measure equity valuation is almost as extreme as it was in early 2000.

I can't vouch for the data behind the ZH graph, but I can vouch for the data used to create the above graph. In my experience, the S&P 500 index has been the best measure of the performance of the U.S. stock market, and it has also been the best proxy for the value of U.S. corporations. What I think this graph shows is that the ratio of company valuations to GDP is not yet extreme, being approximately equal today to what it was in the early 1960s when inflation was low and stable and U.S. interest rates were low and stable, much as they are today.

If I had to guess, I would say that over the next several years nominal GDP growth will pick up (it was a meager 1% or so in the first half of this year), while the growth of equity prices will slow down. Both of those developments would be consistent with higher bond yields and a leveling off of the equity/nominal GDP ratio. In other words, we're not necessarily in an equity bubble, and an equity bubble is not necessarily inevitable.


steve said...

academic argument in my view. timing stocks is an exercise in complete futility and that includes any valuation metrics. too much unknown about the future vs the past to "backtest" your way into any useful conclusions. buy and hold or go elsewhere. said...

More of the S&P 500's earnings come from foreign sources compared to prior periods.

William said...

The wild card maybe - as always - an exogenous event: Syria / Iraq, the Ukraine, Israel / Palestine, etc.

I am particularly concerned about the Ukraine. Many talking heads are encouraging Europe and the US to "get tough" with Russia by more forceful sanctions.

And Russia has warned the Ukraine that it may stop importing all good from the Ukraine which account for ~ 50% of the Ukraine's GDP. And Russia still hasn't been paid for the natural gas that the Ukraine has already used.

Thirdly we have seen what an old SAM (SA-11) missile can do in the hands of rebels. There are also a lot of fairly sophisticated weapons from the failed state of Libya available.

I think that the market would not react well to things unraveling in the Ukraine along the lines of the Russian threats.

Benjamin Cole said...

I tend to agree with Scott Grannis; after five years of recovery, property and equity markets are no longer cheap, but are they expensive?

The average p/e is a little high, might take a haircut. Property here and there a little rich.

But where can capital go? Into bonds?

This will be the permanent conundrum going forward.

Risky, but mortgage REITs might be a good play here.

Scott Grannis sees higher interest rates in the future. I wouldn't bet against Scott Grannis, but we may actually see lower rates in the future.

The Fed is halting QE. Growth is subpar. Obama brought Obamacare, to add on to Bush's Medicare Part D and vastly enlarged and expensive national security state.

We could see 1.5 percent on 10-year US Treasuries in another year or two. The 30-year trend in inflation and interest rates is down, btw.

Grechster said...

The relationship between rates and the level of the SP500 is actually more attractive today than it was in the early 60s. Then again, GDP was growing 2.5-6.5% per year back then. Something to consider.

Anonymous said...

Buffet's ratio is actually the market value of the S&P 500 relative to GDP. It looks like you are using the S&P Index value to GDP?

Scott Grannis said...

The S&P 500 index is equivalent to the market value of those 500 stocks

Anonymous said...

Businesses have become very efficient which happens at the bottom of a cycle. I am less than sanguine because of a study I did last week. I compared the percentage of the income sources of wages/salaries, dividend income, interest income, and rental income, to GDP. I went back as far as FRED would go.

Interest income has lost ground a lot. Not surprising as interest rates have been engineered down for a long time. Dividend income has gone down but pretty much held its own. Wages/salaries have gone way down while rental income has gone way up. So there is an answer to why income inequality. There has been a transfer of income from the many to the few.

Economic growth will be inhibited unless the many can have increased incomes or expand their credit. That or the top 15 or 20% is going to have to carry the ball to the goal line. Maybe they can.

McKibbinUSA said...

Watch for GDP growth to rise sharply if the US enters the wars in Iraq or Ukraine -- Fox News is engaged in a very determined warmongering campaign designed to get the US involved in these wars -- my guess is the US will be leading a world war sooner than many suspect in order to accelerate the repeal and constitutionally outlaw Social Security, Medicare, Obamacare, and all entitlements -- the military-industrial Republicans and Democrats in Congress will not rest until the US is engaged in combat operations in multiple theaters -- the US will need 100% of its wealth and manpower to lead these global wars effectively over the rest of the 21st century...

Grechster said...

Scott: The more I contemplate this chart, the more I think your point is an excellent one - that Buffett's good observation about market value to GDP needs to be further colored by where rates stand.

I wonder if, like in a DCF analysis, an override judgment must be made when rates become abnormally low (as they seem to be right now). Indeed, the market seems to believe, based on this chart, that the "true" ten-year yield should be 4.5%.

Perhaps this is consensus, but doesn't this chart hint at the plausibility of the following: GDP plods along at 2% for the foreseeable future, the market keeps pace with GDP and perhaps a percent better (so the blue line stays flattish to slightly up) and the ten year drifts toward 4-4.5% (closing the gap between the red and blue line). This would also have the effect of making both the bears and the bulls wrong; just a dull but positive market (and consistent, incidentally, with the monetary stability we've seen for the past 12 months).

Would welcome any thoughts.

Scott Grannis said...

That's certainly a plausible scenario.

Anonymous said...

"The S&P 500 index is equivalent to the market value of those 500 stocks"

No, the divisor * S&P500 index value = market value of those 500 stocks. The divisor is not a constant. Buffet's indicator is the "market value of" the S&P500 divided by GDP or GNP (not sure which he meant originally). It is much easier to rationalize a dollar value in both the numerator and denominator. Just saying. I appreciate all of your good work.