Buffet’s Market Timing Signal: Expensive

Buffet’s Market Timing Signal: Expensive

November 5, 2013 Uncategorized
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(Last Updated On: May 9, 2014)

First, you gotta read Warren Buffett’s classic piece from 1999:

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

Buffett highlights the inextricable tie between GDP growth and corporate profits. GDP growth is the limiting factor (interest rates and margins are the other factors).

And here is his follow up in 2001:

http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/

Recently, there have been a spat of articles related to macro valuation signals and the stock market. Many of these articles talk about “Buffet’s favorite valuation tool.”

An example:

Why is Market Cap / GNP considered Buffett’s favorite? He said so…

“…probably the best single measure of where valuations stand at any given moment.”

–Warren E. Buffett from 2001 Fortune article

Gurufocus has a great article on the topic and some associated tools:

http://www.gurufocus.com/stock-market-valuations.php

Below is a chart of the Market Cap to GNP ratio since 1952 along with associated 5-year rolling percentile bands to indicate times of “excess.”

We are able to extend the ratio past the Wilshire 5000 data via CRSP, and you can also recreate a proxy via market-cap breakpoint data from Ken French’s website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

Data on GNP/GDP only goes back to 1947 so we can’t do better than that.

Currently, the ratio stands at 1.224x.

Microsoft Excel - mc_gnp
[Click to Enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
And here are some summary stats from 4/1/1947 to 10/31/2013:

179
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Key takeaways?

  • Expensive, but not unprecedented.
  • Broke the rolling 5-year 95 percentile breakpoint.
  • Mean reversion to long-term mean of .70 would imply SERIOUS market drawdowns.

But what are the alternatives? 2.5% 10-year treasuries?


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.