Is the Buffett Indicator any good?
It does in my opinion indeed indicate that corporations are overearning and investors are overpaying.
TLDR Summary
The total market capitalization of US stocks currently sits at 200% of GDP, more than twice the level where it usually has been in the past. Government deficit spending is the main driver for this. US corporations are the biggest beneficiaries of this deficit spending because much of it flows straight into their profits. It’s possible to quantitatively demonstrate that they receive much more from the honeypot than households and foreigners.
This may be structural to some extent. US corporations are containers for the immense power of the US economy and its global reach. This can continue for a long time. However, there may also be a sizable cyclical component. Other participants in the US economy may eventually claim a bigger piece of the pie.
When businesses are cyclical, their valuation multiples are typically countercyclical. At the peak of its profit cycle, investors tend to assign a lower multiple to a business because they anticipate a downturn. And multiples expand into the trough of the downcycle afterwards pricing in the coming rebound.
The current valuation of the US stock market does not exhibit this negative correlation between earnings and earnings multiples. Both are close to record levels, pointing to a high risk for a systematic mispricing.
We live in the best possible world for US corporations. The government doesn’t tax their profits much and in fact provides endless demand for their goods and services through deficit spending. Consumers accommodate high margins. Employees concede much of their productivity gains. Lenders ask for very low credit spreads. And investors pay record high multiples on their record high earnings, ignoring any cyclical downside risk. The problem with that is: The better things are, the harder it is for them to get even better.
What is the Buffett Indicator?
The Buffett Indicator is the ratio between the total market capitalization of the stock market of a country and its GDP. The first time Buffett publicly spoke about this metric was in a 1999 interview with Fortune magazine.
In that interview, he argued that forward returns of the US stock market will likely be poor as its valuation appears stretched when taking interest rates and the share of corporate earnings in GDP into account. His prediction aged quite well, for some time at least. The S&P 500 was pretty much flat over the next 10 years which made his metric quite popular.
The logic of the Buffett Indicator is straight forward: