As the S&P 500 continues to shatter records, an indicator used by billionaire Warren Buffett suggests a stock market crash is coming. The ‘Oracle of Omaha’ has followed this metric several times and it’s helped him build enormous wealth. Right now, the indicator is reaching alarming levels, a sign that an economic collapse may be imminent.
The indicator I’m referring to measures the value of a country’s stock market against the size of its economy—what economists call the ratio of stock market capitalization to gross domestic product (GDP). When the equity market begins to dwarf the nation’s actual output, there is a problem. (Source: Business Insider, November 4, 2015.)
Mr. Buffett is the world’s most famous investor for a simple reason: he wins. Time and again, the Mid-Western native invests in strong businesses that score him huge returns. He doesn’t use any fancy techniques. Instead, he examines the company’s fundamentals and its position within the industry. Mr. Buffett employs the same strategy for gauging macroeconomic conditions.
How much money is in the stock market right now? How much value is the economy producing? Do those two numbers make sense together, or do they signal a bubble? These are simple questions with a clear line of reasoning, yet Mr. Buffett’s signal gets lost in the continuous noise coming from financial media outlets.
Market Cap to GDP Ratio
The most recent market cap/GDP data from the Federal Reserve Bank of St. Louis is from 2011, so we found a substitute. Haver Analytics put together a chart comparing the total value of the S&P 500 and U.S. GDP.
In the past 20 years, we’ve had two significant stock market crashes. The first occurred in 2000 as a product of over-investment in dot-com stocks, otherwise known as internet companies. The second, in 2007 and 2008, was an economic catastrophe ignited by the failure of several large investment banks.
The chart above demonstrates a quantifiable relationship between market cap/GDP ratio and stock market crashes. You can see the chart spike from 1999 to 2000 as the internet bubble fed on investors’ “irrational exuberance.” The market absolutely collapsed as people began to question how internet companies could make money. Growth was over-promised and under-delivered, driving the ratio closer to its historical average of 0.60.
The financial crisis in 2008 was more about debt than equity, but unwarranted optimism in the stock market was definitely a problem. The market cap/GDP ratio was able to hover above 0.80 during the early 2000s because of a housing boom. Unfortunately, a lot of those mortgages were securitized and held as financial assets, which in turn bolstered the growth in financial markets. But once again, reality caught up with over-enthusiastic investors and brought them crashing back to reality.
This Time Isn’t Different
Every time the stock market gets overvalued, there’s a long line of pundits and investors ready to tell you why this time is different. These self-proclaimed gurus usually have an interest in maintaining the status quo, but most of them conveniently forget to mention that. So here’s the truth: the same metric that predicted the last two stock market crashes is higher than it was in 2007.
Critics argue that the ratio is distorted by changing circumstances. The global economy isn’t the same as it was in 1999, they argue. Companies on the S&P 500 have shifted their exposure overseas, so the metric should measure the stock market against global GDP. They also argue that changes in tax policy or lower interest rates can spur the stock market to greater heights without affecting the real economy. (Source: Business Insider, July 20, 2015.)
These are paper-thin excuses. Global economic growth is in the doldrums—China’s stock market crashed by 30% and Europe is stagnating. Growth in India and China are slowing significantly as well. It’s true that low interest rates from the Federal Reserve made U.S. equities a safe haven, but that only strengthens the argument that we’re in a bubble. Janet Yellen all but guaranteed a rate hike this year. And when that happens, investors will have to look at the fundamental strength of economic conditions. When it turns out that the economy is lagging far behind the stock market, pessimism will return with a vengeance.