Buffett Indicator and how GDP relates to the stock market
In this article I take a look at the Buffett Indicator, how GDP relates to the stock market, and whether or not this relationship can help us make investment decisions.
Doesn’t everybody know how to make money on the stock market? Buy low and sell high! Easy right!
The only problem is knowing when stocks are cheap and when they are expensive, but here’s where the Buffett’s own indicator comes in.
It is a simple method used to value the stock market. It is the ratio of a country’s stock market capitalization (market cap) compared to that country’s overall GDP.
GDP vs the Stock Market
But wait a minute shouldn’t GDP and stock market capitalization be the same and what is capitalization anyway?
The difference between the stock market and GDP can be seen clearly if we look at a typical world stock market index.
The FTSE All World Index
For example, the FTSE All World Index is a popular index. Many funds such as the Vanguard FTSE All World UCITS ETF use this index to enable investors to put their money to work throughout the world.
The FTSE All World Index covers 90-95% of the investable stock market capitalization of global stock markets. It provides market capitalization data for 49 countries.
Sounds good, but at the time of writing, America’s share of this index is 54%. Most people know America is the biggest country in the world, but not that big surely! The chart below illustrates how the world is split up according to capital markets.
Countries by market capitalization (based on the FTSE All World Index)
In fact by GDP America is only 24% of the world. That means America’s percentage of this All World stock market index is about 30% bigger than its GDP.
And how about the world’s second biggest economy, China? In contrast to America, China’s situation is completely reversed. China’s share of global GDP is 16%, yet its share of the FTSE All World Index is a mere 4%. The difference here is -12%.
The world according to GDP is shown below.
Countries by GDP International Monetary Fund (2018)
So what’s going on? Why is the difference so big?
Well, it all comes down to how you see the world. The world in terms of traditional measures of productivity is quite different to the world in terms of stock markets.
Gross Domestic Product (GDP)
Traditional measures of productivity start with gross domestic product (GDP). GDP is the total value of everything produced in a country.
It doesn’t matter who produces the products. All that matters is where they are located. If they are located in the US, then their production is included in US GDP.
That is true even if they were produced by foreigners or a foreign company. So, anything made on US soil by a foreign company is contributing to US GDP.
Market Capitalization
On the other hand, stock markets see the world through the eyes of market-capitalization. Market capitalization is calculated by multiplying the total number of shares of a company by its share price.
For example a company with 10 million shares selling at $100 a share would have a market cap of $1 billion. Add up the companies from a particular country and you’ve got the market capitalization of that country.
So big companies take up a larger share of the market, and then countries with bigger companies take up a larger share of the world. It makes sense really, so why the large discrepancy?
Differences between GDP and market capitalization
Whereas GDP includes just about everything, a market capitalization weighted index only includes shares that are freely traded on stock markets. Only companies that sell their shares on the stock market can be included.
All those companies that don’t join the market don’t get counted. That’s a lot of companies right there! There are lots of gigantic private companies that you can’t buy on the stock market. Big names like Ikea, Aldi, Deloitte and Mars are all private.
On top of that, shares held by insiders or government institutions don’t count either. Because of this a market capitalization weighted index is skewed towards well-developed capital markets and away from countries with large insider holdings.
China compared to the US
So if we go back to China and the US, the differences become a little more understandable. The US has a more well-developed capital market than China, and less insider holdings.
The biggest companies in the US tend to go public. On the other hand, many of China’s largest companies are owned or partially owned by the government. Other large companies like Huawei simply remain private.
Added to this, Chinese companies that do want to list on the stock markets often choose to do so overseas.
There are many examples of this. However, the best examples are Alibaba and Tencent. These are two of China’s most famous companies but they are listed in the US, rather than China. Both these companies do the bulk of their business in China, thus contributing to Chinese GDP.
Another issue is that countries that have highly valued stocks, get a greater percentage of the market, and countries whose stocks are considered less valuable get a smaller percentage of the market. At the time of writing the US market has high valuations, where as China doesn’t.
Finally, less developed countries tend to have less developed stock markets. These stock markets have weaker regulations, less liquidity and people are less confident to invest in them. The US market, is bigger, more famous and considered more reliable than China’s stock market.
Chinese companies incorporated on the Chinese mainland and quoted in the renminbi are known as A-shares. Whereas the US and European stock markets are mostly traded by expert money managers, 86% of China’s A-shares are held by amateur retail investors.
Retail investors tend to have a shorter term investment horizon, and a higher likelihood of panicking when markets go down. Both of which, are likely to make a market more volatile.
The end result of this is China’s share of global stock markets is much smaller than its share of global GDP, where as America’s situation is reversed.
Global growth
Another area where the stock market doesn’t mirror GDP is growth.
Lots of people see a country’s GDP growing quickly and think they should invest in that country’s stocks. Lots of people are excited by the idea of investing in China or emerging markets for that very reason.
Unfortunately, it doesn’t work like that. In fact, would you believe that the opposite is true? Here is what Professor Jeremy Siegel says in his book Stocks for the Long Run:
It will probably surprise readers to learn that there is a negative correlation between economic growth and stock returns, and this finding extends not only to those countries in the developed world but also to those in the developing world.
Jeremy J. Siegel – Stocks for the Long Run
Stocks for the Long Run contains a comparison of developing countries between 1988 and 2012. As you may have guessed, the country with the largest real per capita GDP growth was China.
China grew at 9% per year during the period. However, if you’d had invested in China’s stocks at the same time, you would have lost over 5% per year!
And if you think that was the exception, contrast it with the situation in Mexico, where GDP growth was just over 1% a year, yet stock market returns were about 17% annually!
So if we can’t use GDP growth to help make investment decisions what can we do?
It turns out that there is a method to value stock markets by comparing them to GDP called the Buffett Indicator.
The Buffett Indicator
Though officially known as the stock market capitalization-to-GDP ratio, the term Buffett Indicator is preferred by many because it was Warren Buffett who popularized its use.
In Fortune Magazine in 2001 he said that:
It is probably the best single measure of where valuations stand at any given moment.
Warren Buffett
As arguably the most successful investor in the world, people tend to listen to anything Mr Buffett has to say.
It can be used to value individual markets and it can be used to value the global market.
The formula is simply the stock market capitalization divided by GDP.
- Buffett Indicator = Stock Market Capitalization / GDP
Using the FTSE All World index for market capitalizations and the International Monetary Fund (data) for GDP data we can calculate the Buffett Indicator for any country and all countries together.
Here’s the Buffett Indicator in action for the US, UK and Global Stock Markets:
- US Market Cap is $25 trillion / US GDP $20.5 trillion = 1.22 or 122%
- UK Market Cap is $2.5 trillion / UK GDP $2.8 trillion = 0.89 or 89%
- Global Stock Market $46 trillion / Global GDP $85 trillion = 0.54 or 54%
The US is 122%, the UK is 89% and World is 54%. But what do these numbers actually mean?
Well, it is said that the stock market is undervalued when it is below 50% of GDP. Above 115% means it is overvalued and anywhere between 75% and 90% is just about right.
So it turns out global stocks look good, the UK looks OK but the US looks pretty overvalued right now.
The Buffett Indicator is based on a simple concept. If the stock market capitalization is too low, excess capital will flood the markets and prices will increase. If the sock market capitalization is too high, there won’t be enough cash in the economy to support prices and they will drop.
So do you need to be pulling your money out of US stocks right now? Not, so fast! Just because the market is considered overvalued doesn’t mean there will be a market crash in the near term. More likely, it means returns are likely to be reduced somewhat until the market evens itself out.
On top of that not everybody thinks the Buffett Indicator is something you should use.
Reasons to avoid
Some argue the Buffett Indicator is no-longer applicable as the markets have gradually drifted upwards over time.
Others point out that it is fatally flawed. That’s because if the number of companies that decided to float on the stock market increased i.e. through initial public offerings then the it would be raised automatically for no other reason other than this.
Market timing
Perhaps, something even more important to consider is this: If you base a decision on whether to buy based on anything like this you are essentially market timing.
Market timing is a trading strategy, where indicators are used to instruct an investor or trader when to move in and out of financial markets or when to switch between alternative investments.
Though it sounds good in theory, it is rather different in practice. Though we would all like to get in and out of the market at the right moments, it has proven time and again to be a notoriously difficult thing to do.
Here’s a quote from the founder of Vanguard, and purveyor of the first index fund, John C.Bogle from his book Common Sense on Mutual Funds.
The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.
John C.Bogle – Common Sense on Mutual Funds
In fact, most investors are better off just staying in the market through the good times and the bad.
Pulling your investments out of the market because you think it is too expensive can be severely detrimental to your investment returns and there is lots of research to back this up.
The graph below from Vanguard shows a 30 year period from 1986 until 2016. The blue line is the return of the FTSE All-Share Index, which is an index of the UK stock market.
The grey line also shows the FTSE All-Share Index, but doesn’t include the 10 best days.
If you had missed the best 10 days you would have lost just about half your return!
The bottom line
I think it is pretty clear that GDP and stock markets are related but not very well.
Nevertheless, some people still try to exploit this difference to make investment decisions.
They may use GDP growth or the Buffett Indicator, even though it is not clear that either of these are effective.
In fact there’s a wealth of research out there that questions the effectiveness of using any indicator to time the market.
Some investors may want to use the a tool such as Buffett’s alongside some other indicators. However, most investors are probably better off avoiding market timing all together.
Instead, most investors would be better off simply choosing a mix of stocks and bonds that they are comfortable with and sticking with it no matter what.
