Buffet Factor or Legit Metric?

by Broke

A simple metric to determine if the stock market is undervalued, fairly valued, or overvalued might be the total market value of US stocks as a percentage of Gross National Product (GNP). According to an article in the February 4, 2009 edition of Fortune Magazine, this ratio peaked at 190% in March 2000. The ratio had never exceeded 100% between 1924 and 2000. Compared to the historical norms, this high ratio may indicate that the stock market is overvalued. In the case of March 2000, it could be categorized as significantly overvalued.

In 2001, Warren Buffet referred to this ratio as “probably the best single measure of where valuations stand at any given moment”. He also stated that, “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you”. In January 2009, the metric fell to 75%, right in the sweet spot of Buffet’s range. The S&P 500 index rallied 5.2% in the first week of February. Hmmm…chicken or the egg? Did the rally happen because of the Buffet article published on Feb. 4? The chart sure looks like it. The rally fizzled on Monday, so for the short-term, I think this pop was purely due to the “Buffet factor”. Besides, according to the chart, it looks more like under 50% should be the sweet spot, not Buffet’s recommendation of 70-80%. Hey, who am I to argue with a billionaire? I’m just a Broke Wall Streeter.

As always, use this metric in addition to other models and indicators. Don’t rely on a single metric to determine your long term investment strategy. Click to enlarge the illustrations below.