Market Pricing: Warren Buffett Indicator

Dividend yields are no longer an accurate reflection of market valuation because of the distortion from stock buybacks. Price-earnings ratios are also susceptible to fluctuating profit margins. Instead we rely on Warren Buffett's indicator — the ratio of stock market capitalization to GDP — and the price-to-sales ratio for the S&P 500, to warn when markets are over-priced.

Warren Buffett's Indicator

Stock market capitalization, representing the market value of all listed corporations, grows at a similar rate to total output for the economy (GDP). So variations in the ratio of stock market cap to GDP are normally the result of investor exuberance or pessimism. Values above the long-term average of 1.03 warn that stocks are over-priced, while values below that indicate stocks are under-priced.

Warren Buffett's Indicator: Stock Market Capitalization/GDP

Price-to-Sales

Price-to-sales for the S&P 500 also avoids distortion from fluctuating profit margins. Values above the long-term average of 1.68 warn that stocks are highly priced, while lower values indicate under-pricing.

S&P 500 Price-to-Sales Ratio

Summary

Warren Buffett's indicator — the ratio of stock market capitalization to GDP — and the price-to-sales ratio for the S&P 500 are useful measures of stock market pricing as they avoid distortions from fluctuating earnings and profit margins. Both are currently well above their long-term averages, warning of over-pricing.

Colin Twiggs

Author: Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.

He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.