The Buffett Indicator

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On the brink of the new millennium, the legendary value investor Warren Buffett studied the fundamentals behind the exceptional performance of the Dow Jones Industrial Average between 1981 and 1998 compared to its poor performance during the equally long period between 1964 and 1981. From 1981 to 1998, the Dow Jones index increased almost tenfold despite much slower economic growth than in the previous seventeen-year period. Buffett suggested that the market value of equity (MVE) scaled by gross domestic product (GDP) would have forecasted higher returns for 1981-1998 by indicating cheaper valuations for the stock market.

The rationale behind the market value of the equity-to-gross domestic product (MVE/GPD) ratio as the stock market valuation measure is simple. When the equity prices go up without a commensurate increase in economic output, the forward earnings yield decreases, making the equity investments less attractive. On the other hand, if the share prices scaled by GDP fall, the forward earnings yield increases, making equities more attractive. Unlike purely price-based valuation measures, such as the cyclically-adjusted price-to-earnings (CAPE) ratio, the MVE/GDP has the advantage that its numerator incorporates a qualitative (i.e., price) as well as a quantitative (i.e., number of shares) dimension. The model assumes that new share issuance increases (decreases) when equity markets are overvalued (undervalued) if corporate managers are able to time the market.

Despite Warren Buffett’s claim that the MVE/GDP ratio is “probably the best single measure of where valuations stand at any given moment,” its predictive ability has been the subject of relatively little academic scrutiny. A novel paper by Swinkels and Umlauft (2022) fills this gap and examines whether the MVE/GDP ratio can forecast international equity returns, which complements the existing research limited to the United States. Their findings can be summarized as follows. First, based on the data from fourteen developed markets going back to 1973, the “Buffett indicator” exhibits superior forecasting qualities over longer time horizons. More specifically, MVE/GDP explains, on average, 83% of the variation in 10-year forward returns, ranging from as low as 42% for Austria to 94% for Great Britain. Second, when the CAPE ratio and the mean-reversion are included in the predictive regression, MVE/GDP remains significant, suggesting that its predictive ability is not subsumed by other popular valuation signals. Most importantly, these research findings can be utilized in practice. A simple trading strategy that invests in countries with the highest model-predicted returns yields statistically significant and economically meaningful alpha over a corresponding buy-and-hold benchmark while experiencing lower volatility and maximum drawdown.

Authors: Laurens Swinkels and Thomas S. Umlauft

Title: The Buffett Indicator: International Evidence

Linkhttps://ssrn.com/abstract=4071039

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