When Warren Buffett Talks ... People Listen

April 30th, 2013

by Chris Turner

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Okay, E.F. Hutton commercials originally featured the "people listen" tag (for those of us old enough to remember them). I began reading David Stockman's book, The Great Deformation, and found myself writing notes for future research and posts. This first article examines an oldie but a goodie, the Warren Buffett market valuation metric: Market Value divided by Gross National Product. Rather than spending time discussing the metric, follow this link for a good description.

To gain a broad perspective, first in the series of charts shows the current valuation of both the Market Value of Equities outstanding and Gross National Product (available from FRED), adjusted for inflation using BLS CPI data.

The current values for both are right around 16 Trillion (for a ratio of 100%). Warren Buffett uses 80% as a guide to determine when the market is overvalued. However, the Green Line on the chart shows the historical mean, currently around 67%, which would place the fair value of equities outstanding at 11 Trillion (whereas Buffett's 80% rule would place the value at 12.9 Trillion).

The next chart in the series provides a display of the Market Value divided by GNP. To add perspective, the historical mean and S&P 500 Composite are also shown. Each of these has been CPI adjusted as well.

While the green line shows the fair market value based on historical mean (currently 67%), readers may discern that when the MKT/GNP rises above the 80% ratio, it portends a market overvaluation period.

Readers familiar with my previous works to show where the S&P would be trading based on a fair value metric, why not do the same with this metric as well. The following chart shows the S&P composite and what the fair value should be based on both the 80% Buffett rule and the historical mean.

Readers can see from the chart that based on both Buffett's rule and the historical mean, the S&P would be trading much lower from present levels. The S&P would be sub 1000 based on the historical mean and around 1150 based on the 80% Buffett rule.

Hopefully these charts provide context the next time an article references Warren Buffett's favorite method of market valuations.


Note : The last chart above splices the S&P 500, which dates from March 1957, with an earlier S&P index. See this article for details.

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