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.

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.

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.