US Market Overvalued By Buffett Indicator Market Cap To US GNP

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The one indicator that Warren Buffet bookmarked as the only and best method to measure market valuation tells us that the U.S. market is ‘excessively overvalued’. As per the calculations arrived at, the stock market is likely to deliver a return of 0.6% per year at this point of valuation based on the Total Market Index. Currently the historical ratio assessing total market cap with Gross Domestic Product is at 127.5% currently. The return includes dividend yield, which is at 2% currently.

So what does 127.5% mean?

If the ratio is more than 115%, then the market is considered significantly overvalued, while 90% to 115% is modestly overvalued, 75% to 90% is Fairly Valued, 50% to 75% modestly undervalued, and anything below significantly undervalued.

What Is Buffett’s Indicator?

According to Buffett, the market valuation of all stocks as per the Total Market Index should be less than the Gross Domestic Product (GDP) of the U.S. economy. That means that whenever the ratio crosses its mark then it is a sell signal. The current market valuation seems to be in the danger zone as per Buffet indicator as the levels are right near the 2008 levels, the last pullback. Over the last four decades, TMC/GNP ratio oscillated widely from 35% in 1982 to 148% in 2000.

Why GDP and not GNP?

GDP is the total market value of goods and services produced within the borders of a country, while GNP is the total market value of goods and services produced by the residents of a country even living abroad. GDP and GNP are within 1% of each other.

What Should Be The Way Ahead

Though the Buffett indicator might just point out overvalued markets, another of his philosophies should be taken into consideration before running away from the market. Buffett recommends that investors should concentrate on individual shares that are undervalued by the market rather than concentrating on the market as a whole. Over the long run, stock market returns are dependent on interest rate, long term growth of Corporate Profitability and market valuations. On the other hand, the returns on an individual stock are the dependent on business growth, dividends and change in market valuation. Thus, it is always possible to separate an undervalued stock from an overvalued market and generate a decent return out of it.

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

“When Berkshire buys common stock, we approach the transaction as if we were buying into a private business.”

“Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.”

-Warren Buffett

Viraj Shah

Viraj Shah has completed M.Com (Finance) and is currently pursuing his CFP. He tracks US markets along with other global markets like India very closely. He is very passionate about stocks, real estate, and technology. He also believes that money can always be made in the market.

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