There seems to be considerable disagreement about the level of the stock market these days. Is it over valued? Undervalued? Correctly valued? How do you tell for sure? In this two-part series, we'll take an in-depth look at the most popular stock market valuation tools. We'll look at the date of origin and the level of predictive value for each. In this article, we'll begin with Warren Buffett's preferred measure, Total Market Cap to GDP.
Total Market Cap to GDP
This particular valuation method received high praise from Warren Buffett in 2001 in an interview with Fortune magazine. In the article, Mr. Buffett remarked, "…it's probably the best single measure of where valuations stand at any moment." Let's examine when it began, how it work, and how reliable it is with respect to signaling when the stock market is at its peak or primed for a decline.
This stock market valuation tool was first released in December 1970. It uses the total stock market capitalization in the numerator and GDP in the denominator. Total stock market capitalization is equal to the share price of all publically listed securities multiplied by the total number of shares outstanding. The market cap to GDP valuation ratio is expressed as follows:
((Total Stock Market Capitalization / GDP) x 100) = Stock Market Valuation %
This ratio utilizes the Wilshire 5000 Stock Index which is the most comprehensive index for U.S. stocks. This is also Wilshire's flagship index and includes all public companies trading on U.S. exchanges and for which price data is available. (Here's a link to an interactive chart for the Wilshire 5000 index as published on the St. Louis Fed's site).
It's important to properly interpret the ratio but that's where things get hazy. Even though this ratio provides insight into the market's valuation at a given point in time, because trading is done by humans, there is also an emotional component which this and most other ratios fail to include. Because humans prefer concrete metrics over the abstract, we tend to approach this and other measures from a logic point of reference. In reality, the aspect of human behavior plays a significant role, rendering black-and-white interpretations somewhat obsolete. All of this reminds me of a trading maxim which says:
"The market can remain irrational longer than we can remain solvent."–Anonymous
In other words, if we decide to make decisions based on this or some other rigid measure, we may miss out on a sizable amount of stock market upside. The reverse is also true, in that if we choose to ignore it, we will likely experience substantial losses. Therefore, it's important to pay attention to it, but use your own judgment as to how it will influence your investment decisions. With this as a backdrop, let's turn our attention to the ratio's current reading and examine some periods in the past when it was flashing red.
Predictive Value
The key with any tool of this nature is its predictive value. However, as we have already discussed, because of the human element, this type of tool will not provide the user with the consistent and accurate indicator we desire. Even so, it is certainly useful and, with prudence, can serve as an excellent measure of the valuation of stocks.
The following chart shows how this ratio has changed since its inception on December 31, 1970.
