If you follow some of the popular investing websites, you may have seen the flashy headlines reporting that Buffett’s favorite valuation indicator is back to internet bubble levels.
It is quite true.
The Buffett Indicator is indeed approaching 1999 and 2000 levels, suggesting that the market is “strongly overvalued.”
That’s terrifying, isn’t it?
A little, sure. But it deserves a closer look.
Debunking Buffett’s Indicator
Given where we are in the world, Buffett’s favorite valuation indicator is interesting but not really relevant.
For starters, this ratio compares the total market capitalization of all U.S stocks against gross domestic product (GDP).
Buffett told Fortune magazine in 2001 that this ratio was a pretty good indicator of where valuation levels fell historically:
For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.
I am a huge believer that valuation is critical to long term investing success. Hell, I even check the market cap to GDP ratio (also known as the Buffett Indicator) regularly because it is a pretty good indicator of where we are in normal times.
But here’s the thing: these are not normal times.
We just had one of the most significant drops in GDP in history because of the economic shutdown caused by the virus. Furthermore, the decline happened as stock indexes were being pushed dramatically higher, largely thanks to the government’s ability to print money.
Also, Interest rates are at levels that would seem to allow for valuations of something close to infinity.
If I used today’s risk-free rate and current earnings estimates – and had a lot of bourbon first – I could make you a case that, based on discounted earnings, the S&P 500 should trade at about five times the current level.
I would be convincing, but wrong.
The coronavirus is still running amuck in many states. As schools and universities attempt to reopen, we see many mini-outbreaks. Lots of businesses are still closed or operating at minimum capacity. Several states look to be on the verge of sending everybody back in the bubble.
At the same time, the Fed is pumping money as fast as they can. I think we all underestimated how much money they could put out into the world so quickly. They have not missed a chance to remind us they are willing to keep doing it either.
After an initial bipartisan effort, Congress has gone right back to the asininity that is two-party politics in the modern age. They may find some sense of urgency as the number of people falling behind on rent continues to grow as do mortgage delinquencies.
One can only hope.
Is it Time to Sell?
Just because valuations are high, it doesn’t mean it’s time to hit the panic button and sell everything in your portfolio. After all, excessively high valuations are nothing new…
I have been saying that valuations are extremely high for several years now.
Did I sell based on that?
Every single timing model and trend following system I use, even before the virus, was stubbornly long the entire time.
Interest rates were low, and the economy was in decent shape. Valuations may have been stretched, but there was no reason to sell.
In my bank portfolio, for example, I did allow cash to build by not adding to new positions.
But it was not because I was beginning to panic. It was simply because I could not find any new banks to buy at prices I was willing to pay.
We have seen some recovery in the markets, thanks to the Fed.
Aid packages from Congress and the fantastic technology developed in the last year kept us from seeing the worst economic crash ever. Bar none.
If we get a vaccine, GDP will move higher, bringing the ratio into line with reality.
If we don’t get a vaccine, stock prices will fall because it will get a little ugly on Main Street.
While Buffett’s Indicator provides a great headline, it shouldn’t propel us to make any drastic moves. Not yet, at least.
We have seen a lot of headlines suggesting that it is time to either buy or sell stocks. But both are equally ignorant.
What Should You Do?
Not much, honestly.
No one knows what the broader markets are going to do. The virus and the Fed, with an assist from the upcoming election, will plot that course.
Our job as all this unfolds it to dig in those corners of the market where very few others are looking to find opportunities for massive gains.
Ignoring the headlines and following the money is the right course of action in the midst of the current weirdness.
Fortunately, I have spent a lifetime perfecting my strategy that does just that.