Here’s what Warren Buffett said about the ‘Buffett Indicator’: Morning Brief

Lately, the Buffett Indicator has been flashing a warning sign about the stock market. Yahoo Finance’s Myles Udland breaks down what Warren Buffett had to say about it.

Video transcript

BRIAN SOZZI: We have to start earnings season with JPMorgan, Wells Fargo, Morgan Stanley, and Goldman Sachs, all out with results. March retail sales data is also on the way.

And Myles, all this comes against the backdrop of the market trading at some of the loftiest valuations in 10 years or so. This was a key topic in the Morning Brief newsletter this morning.

MYLES UDLAND: Yeah. So there's a number of ways to break up valuations. If you look at multpl.com-- that's M-U-L-T-P-L dotcom, that's Robert Shiller's easy PE calculator-- you'll see that valuations right now are approaching record highs. Now that is inclusive of a huge decline in earnings last year, also includes some of the impact from the financial crisis about 10 years ago.

So valuations are high, right? We hear that all the time. Sam Ro wrote in the Morning Brief last week, which we discussed, that valuations against this year's forward earnings estimates actually haven't moved over the last nine months. The S&P has been trading at about 22 times those forward earnings. And so we continue to see the market react to better earnings news.

Another way of looking at the valuation of the market against the whole economy is the so-called Buffett Indicator. This takes the market capitalization of US stocks and compares it to US GDP. And right now, the Buffett Indicator is at a record high. It's about 200% is the ratio of the corporate equity market cap relative to GDP.

What does that mean? Well, maybe something, maybe not all that much. Warren Buffett himself, back in 2001, said that the ratio has certain limitations in telling you what you need to know. So Warren Buffett doesn't think that an indicator named after him is the end all, be all for judging the value of the stock market. What the Buffett Indicator absolutely does tell us is that relative to the total economic output of the US economy, the stock market's valuation is quite high.

Now we have a couple of issues here with the data. There's a number of issues comparing this data to historical market capitalizations because of the import that the stock market has taken on within an increasingly financialized economy over the last several decades. So let's say comparing the market cap of all publicly traded equities and 1965 to 2021 is certainly not apples and oranges. It might not even be fruits and vegetables. It's basically a different sport.

Another problem is that the stock market's valuation is calculated on a real-time basis. So today, we can go through and we can add up the value of every publicly listed US company, or even just take the S&P 500, and you'll get to some number, again, in the tens of trillions of dollars. It'll land somewhere in that ballpark. US GDP total output, that's going to be backward looking.

So we don't yet have an estimate for first quarter GDP output. We are anticipating a huge ramp in the total dollar value of US GDP output in the second quarter and third quarter and fourth quarter of this year. And if we compare that value to today's total market capitalization, the Buffett Indicator would look quite different. But again, we're comparing one real-time data set with one very [? lagging ?] data set.

So all of these come into play when looking at what is the perfect indicator for the market. And indeed, there is no perfect indicator, Sozzi. But everyone likes this one, mostly because of the guy's name who's in it. But Warren Buffett himself, of course, admitting that no measure, his or anybody else's, is going to tell you the key for what it means, what the stock market today means, what it could mean, and what it doesn't mean, all those sorts of good things.

BRIAN SOZZI: Yeah, Myles. People love writing or just reading about the Buffett Indicator. Hence, I know I am always writing about the Buffett Indicator, and those articles are out there.

But I think we're learning, Myles, that valuations-- look, doing those historical comparisons right now no longer makes any sense. Why can't the S&P 500 trade at a 30 times forward multiple-- right now, it's about 22 and 1/2, that 10-year average is 15.9-- given where growth is likely to be over the next few quarters?

MYLES UDLAND: Yeah. And you know, and again, I think the Buffett Indicator here is so instructive in thinking about the mismatch in time series. And I know we're getting very granular here. But again, the value of all publicly traded companies is calculated every day. The output of the entire economy is estimated four times a year. Then it's revised three times within the same year. Then it gets revised annually over subsequent years, such that we are still today guessing at what 2017's total economic output was, for instance.

And so I think trying to look too deeply into these numbers leads you into, can certainly lead you into the wilderness. And I'll come back again to that note from Jon Golub of Credit Suisse, which came out now about two weeks ago, saying that the forward estimate for the stock market today has not changed in nine months.

So we talk a lot about valuations. We look at different metrics for saying, what is this stock market worth, what is it not worth? But the simplest ratio, which is the stock market today priced against expected earnings over the next year, has not materially changed, hasn't changed at all in the last nine months.

And I think that, today, is the biggest story as it relates to valuations for the stock market. People have not really changed how much they want to pay for shares of the S&P 500. They have only said companies are likely to earn more in profits inside of that basket. And I think, again, that's the simplest valuation story as we head into a very exciting first quarter earnings period getting started this week.

BRIAN SOZZI: Impressive analysis, Myles. That's why I'm glad I'm a subscriber of the Morning Brief newsletter.

All right, switching gears just a bit--

MYLES UDLAND: Free. Free for everybody.

BRIAN SOZZI: Free is good. Free is good.