What’s the Buffett Indicator and How Should Traders Use It?

Warren Buffett is one of the most respected investors of the current generation. He is a widely followed figure who is beloved for what he has achieved. Buffett has successfully managed Berkshire Hathaway for more than 60 years. His success has helped the company to become highly valued. It has a market capitalization of more than $660 billion, making it the eighth biggest company in the world.

In this article, we will look at the so-called Buffett indicator and whether it is still relevant today.

What is the Buffett Indicator?

To understand what the Buffett indicator is, we need to look at how Warren Buffett invests. For decades, he has embraced a strategy known as value investing. Simply said, this is a strategy that hopes to identify and invest in highly undervalued companies.

The goal is to hold them for a long time hoping that investors will one day realize their value and put a good valuation on them. This is why Buffett has invested heavily in companies like Apple, Bank of America, Wells Fargo, Coca-Cola and American Express, among others.

The Buffett indicator is a relatively easy one to understand. It simply looks at the market capitalization of all companies public in the United States and compares them with the GDP. The idea is that if the number is extremely low, it means that companies are undervalued. Similarly, if the number is extremely high, it means that stocks are extremely overvalued.

How to calculate it

As described above, the Buffett indicator is calculated by dividing the total market cap of all publicly traded firms and the US GDP. To get the total market cap, the index uses the Wilshire 5000 index. This is an index that was developed by Wilshire Corporation.

At its launch, it had 5,000 companies. However, the number of companies has been rising and falling since then. At its peak, the index had more than 7,500 companies. Today, the number has fallen to about 3,500 because of mergers and acquisition and delistings.

When it was launched, all companies in the index were valued at more than $1 trillion. Today, while the number of companies has fallen, the total value has surged to more than $50 trillion. This is evidence that American companies are getting bigger over time.

The GDP, on the other hand, refers to the total output of an economy. It looks at consumption, total government expenditure, investments and net exports minus net imports. The American GDP has been rising over the years. At the time of writing, it stands at more than $21.4 trillion.

Therefore, the Buffett indicator is calculated using the following formula:

Buffett indicator = (value of all public companies/GDP of the country) X 100

For today, the Buffett indicator is (50T / $21.4T) X 100 = 233. This is represented in the chart below.

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Is the Buffett indicator still applicable?

While the Buffett indicator used to be used well by many investors and traders, the reality is that it is now not all that relevant. For one, many companies in the United States are not American firms. This includes giants like Alibaba, Taiwan Semiconductor, and Toyota.

Further, most of these companies do a lot of business abroad. For example, while Apple is the biggest firm in the United States, it does most of its business abroad. The same is true for companies like Microsoft, Facebook, and Google.

In addition, when the Buffett indicator was developed, many of the constituent companies were in the manufacturing, retail, and energy sectors. Today, the biggest companies in the United States are in the technology industry.

FED’s influence

Most importantly, the indicator did not factor in the actions by the Federal Reserve. When it was started, the Fed had not started doing quantitative easing (QE). Today, the Federal Reserve has added more than $7.3 trillion in its balance sheet. This has led to a situation where many asset prices have surged.

Most importantly, company valuations have surged substantially. For example, 4 companies – Apple, Microsoft, Amazon, and Alphabet – are all valued at more than $1 trillion each. The four companies have a combined market cap of more than $7.1 trillion. This makes them worth than all countries in the world other than the United States and China. There are also more than 150 companies that are worth more than $100 billion.

In other words, the way companies were valued seems to have surged. For example, all S&P 500 companies had a PE ratio of less than 10 in 1980s. Today, they have a PE multiple of more than 40.

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Fed quantitative easing

How to use the Buffett indicator

The Buffett indicator is one of the many sentiment indicators in the market today. Others are the fear and greed index, CBOE volatility indicator, and the Bullish Percent Index (BPI), among others.

These indicators don’t necessarily tell you whether to buy or sell an asset. Instead, they tell you the market conditions and what to expect in the future.

Therefore, unfortunately, for traders, there is no way of using the indicator because of the limitations we have mentioned above. However, many long-term investors can use it to predict whether stocks are overvalued or not.

Still, a trader can use the indicator to gauge the sentiment in the market. If the index is substantially high, it might be a sign that the stock market is about to retreat, and vice versa.

Final thoughts

The Buffett indicator used to be a relatively popular gauge of market sentiment. However, in the past few years, its efficiency has been relatively weak. Therefore, as a trader, you should only use it to gauge the market sentiment and not as a tool to find buy and sell opportunities.

External Useful Resources

  • What Warren Buffett said about the ‘Buffett Indicator’ – Yahoo Finance

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