Warren Buffett’s favorite stock market valuation indicator, known as the Buffett Indicator, has hit record highs. This implies that the US stock market may be significantly overvalued and due for a correction. However, research from Morgan Stanley has highlighted two flaws in the Buffett Indicator’s methodology.
Michael Mauboussin of Morgan Stanley’s Counterpoint Global explained that US companies now get more of their sales from outside the US than they did in past decades, but GDP does not include those sales. This means the market capitalization reflects a larger addressable market than what GDP captures. The second flaw concerns the changing nature of the economy.
GDP may be understated because it fails to measure accurately the quality and value of new goods and services, especially with the rise of digitalization. Recent research from BlackRock and economist David Rosenberg has echoed this sentiment.
Flaws explained in Buffett Indicator
They point out that comparing today’s index to that of the past is like comparing apples to oranges, given the evolving nature of America’s tech-focused economy. Mauboussin concluded that valuation measures that worked well in the past might not be suited to the current market. He said, “As with most measures, we need to be careful using it when we compare the present to the past.”
Even Buffett himself doesn’t see his own stock market valuation indicator as an all-encompassing tool.
At Berkshire Hathaway’s 2017 shareholder meeting, he mentioned, “Every number has some degree of meaning. It means more sometimes than others. It’s not as simple as having one or two formulas to determine if the market is undervalued or overvalued.”
Despite this, investors and market observers have speculated that Buffett is concerned about current stock market valuations based on his recent investment decisions.
The bottom line is that while valuation metrics like the Buffett Indicator can provide insights, investing requires a broader perspective. There’s no single metric that can consistently tell you everything about market values.
