INVESTING EXPLAINED: What you need to know about the Buffett indicator

In this series, we break down the jargon and explain a popular investment term or theme. Here it is the Buffett indicator.

What is this?

A ratio that aims to show whether a stock market represents good value.

It was coined in 2001 by American stock-picking guru Warren Buffett, manager of the Berkshire Hathaway fund, after the dot.com bubble burst.

He describes the ratio as “probably the best measure of the state of valuations at any given point in time.”

The sayings of Buffett, 92, known as the Wise of Omaha, are gaining even more influence if possible.

His huge fan base now includes younger investors disenchanted with cryptocurrencies and high-risk “meme” stocks looking for companies with long-term potential.

How is it calculated?

The total market capitalization of all stocks quoted on the market is divided by the country’s gross domestic product (GDP).

This returns a value in decimal format, usually expressed as a percentage. In 1999, as the dot.com boom gained momentum, the ratio in the US was close to 200 percent, which Buffett considers dangerous territory.

In 2001 he wrote, “If the percentage drops to 70 percent or 80 percent, buying stock will probably work very well.” The current reading for US stocks, based on the broadly supported Wilshire 5000 index of 3,600 stocks, is 181 percent, indicating a level of overvaluation, though traders seem largely unconcerned.

The reading for the UK, based on the FTSE 100, is 151 percent.

Is the ratio a good guideline?

Opinions differ. In 2007, before the financial crisis, the number was close to 200, signaling that problems were looming.

But critics question the reliability of the ratio, arguing that it does not reflect certain variables. For example, in an era of low interest rates, stocks usually offer better returns, which means investing money in the stock market makes sense.

There would also be a mismatch between GDP and equity market valuations. GDP is a measure of a single country’s output, while companies in the FTSE 100 and Wilshire 5000 have international operations.

Companies in the FTSE 100 derive approximately 75 percent of their revenue from abroad. You can of course conclude that these objections are minor and that no ratio can ever be an infallible guide.

Don’t we have the P/E ratio?

The price-to-earnings ratio (P/E) is the better known indicator of whether a stock or a stock market index represents value or not. The FTSE 100’s PE ratio is currently 10.64, compared to 21.77 for the US S&P 500.

You may think that the Buffett indicator is an additional complication. But maybe with proportions, the more the merrier?

Why are we hearing it now?

It is said that the current level suggests it makes sense to buy Britain.

Despite a strong start, the UK market has not blossomed this year. The FTSE 100 is up just 1.86 percent, against 20 percent for the S&P 500 and 19.55 percent for the Wilshire.

These increases have been driven by demand for stocks that could benefit from the adoption of generative AI (artificial intelligence). We won’t know if Buffett buys Britten until the publication of the list of Berkshire Hathaway holding companies at the end of the second quarter.

At the moment, its only holding is a small stake in beverage giant Diageo.