Few charts look as strong and encouraging as the S&P 500 over the last five years. Since the markets bottomed in 2009, the S&P 500 has soared 215%. While many investors remain bullish, the market cap to gross domestic product (GDP) ratio shows the stock market is seriously overvalued.
Warren Buffett Indicator Points to Wildly Overvalued Stock Market
In a 2001 Fortune Magazine interview, Warren Buffett said the market cap to GDP indicator is “probably the best single measure of where valuations stand at any given moment.”
The so-called “Warren Buffett GDP Ratio” compares the total price of all publicly traded companies to GDP. The Warren Buffett Indicator can also be thought of as an economy wide price-to-sales ratio. A reading of 100% suggests U.S. stocks are fairly valued. The higher the ratio over 100%, the more overvalued the stock market.
If you look at Warren Buffett’s indicator of market value, the stock market is significantly overvalued. Based on the historical ratio of total market cap over GDP, the stock market currently sits at 124.6%. The Wilshire 5000 Total Market Index is at $22,023 billion; which is 124.6% above first quarter U.S. GDP of $17,644 billion. (Source: bea.gov, May 29, 2015.)
According to Buffett’s indicator, the S&P 500 will likely return just 0.2% a year from this level of valuation; that includes dividends currently yielding an average two percent.
Going back to 1950, the Warren Buffett Indicator has only been higher once—in 1999, when it stood at a frothy 153.6%. It was only near 108% before the housing bubble burst in 2008, dragging the stock market down with it.
Strong Economy Should Translate into Higher Stocks, and Vice Versa
The underlying premise of the Warren Buffett indicator is that there is a strong correlation between stock prices and the economy. If the U.S. economy is doing well, corporate profits will be stronger. As profits increase, stocks rise higher. Conversely, if the U.S. economy is not performing well, consumers will be spending less, corporate profits will decline, and the stock market should retrace.
Judging by the S&P 500, the U.S. economy must be on fire. But the fact of the matter is; the S&P 500 and broader stock market have been climbing in the face of weak economic data and underperforming stocks.
Case in point, against the backdrop of a bullish stock market, the U.S. economy has been fragile—and remains so. In 2009, the U.S. economy constricted -2.8%; in 2010 the country’s GDP climbed 2.5%; growing just 1.6% in 2011, 2.3% in 2012, 2.2% in 2013, and 2.4% in 2014. (Source: Worldbank.org, last accessed June 9, 2015.)
In the first quarter of 2015, the U.S. economy shrank at an annualized pace of 0.7%. This represents the third quarterly contraction since the Great Recession. Many were expecting the U.S. economy would perform well in the first quarter thanks to cheap oil, improving unemployment numbers, and growing consumer confidence. But, it didn’t. And it continues to show how fragile the U.S. economy is.
Going forward, the Federal Reserve Bank of Atlanta predicts the U.S. economy will grow at just 0.8%. If so, that would translate into six months of economic stagnation; not the best growth trajectory for the world’s biggest economy. (Source: washingtonpost.com, May 29, 2015.)
Is a Correction Just Around the Corner?
The seriously overvalued stock market needs to take a breather at some point. Unfortunately, most investors are not prepared for any sort of retracement. It’s important for investors to add downside protection to their portfolio.
This could mean Treasuries and high-quality bonds, exchange-traded funds (ETFs) that go up when the markets go down, or precious metals (either physical gold and silver, stocks, or ETFs).