Mathematically, the Buffett indicator is quite simple. It is obtained by dividing a country's total market capitalization by its gross domestic product.
At the time he proposed this ratio in a Fortune magazine article co-authored by journalist Carol Loomis, the Omaha pundit thought it was "probably the best single indicator of where valuations are at any given time."
He explained that if the ratio approaches 200%, as it did in 1999 and 2000, "you're playing with fire." In other words, the markets are overvalued. And if the indicator points above 70% or 80%, then buying stocks can be really profitable for investors.
And that's exactly what the index is for: to get an idea of market valuation. Is it overvalued? Is it undervalued? Or maybe it's just well priced?
All in all, it's a good indicator to put the market in perspective when you need to determine whether it's expensive or not. But it's not definitive because it only gives a general idea.
In February 2021, the Buffett indicator reached an all-time high of over 200%. Since then, markets have retreated and the indicator has also fallen.
In mid-October, when U.S. annual GDP was $25.5 trillion and all markets valued at $39.1 trillion, according to the Current Market Valuation website, the ratio for the U.S. was 151%.
It's still above historical averages, but with the stock markets falling, we're back in a more reasonable range where the market is better valued. However, using the index in Canada is more difficult given that Canadian markets are more cyclical because they are more resource-based.
This ratio is similar to cyclical because Canadian markets are more resource-based. It is also very similar to the price-to-earnings ratio. The ratio can and should be considered in conjunction with the Buffett indicator, because you should never rely on just one ratio in isolation.
Because the Buffett index, like all others, is not without its pitfalls.
Warren Buffett was the first to admit it: his ratio is imperfect. The ratio has certain limitations.
The first limitation is that public markets do not represent all companies in the economy.
The ratio takes into account only public companies. But the proportion of public and private companies can change over time. And if there are more public companies, the ratio will be higher. But this does not necessarily mean that the market is overvalued, or at least expensive.
The second caveat is that the ratio ignores the profitability of companies. What gives companies value is the fact that they generate profits.
Thus, it is one of the first points -- profitability -- that should be considered in your analysis. For this reason, if you want to determine if the market is overvalued, you will look more at the price-earnings ratio for the market as a whole.
And of course, don't make big investment decisions based on such ratios. After all, even if the market as a whole is overvalued, that doesn't mean there aren't interesting companies in the portfolio.
The third caveat is no less important. Recently, companies have become increasingly international. This was a reality in 2001, but it's even more relevant today.
For example, a company may have warehouses in Europe. But although this economic activity is not counted in the U.S. GDP, the value of the company will reflect that.
This is another inconsistency to watch out for. The bottom line is that even if the indicator is not bad overall, it should be used sparingly, and especially in combination with a number of other indicators.