Does Warren Buffett’s #1 indicator predict big market crashes? Suddenly everyone thinks the stock market is going to tank as Warren Buffett’s favorite market indicator is flashing red. Topping 200%, does this mean stocks are overvalued, and a crash is around the corner? Maybe yes, maybe no. With that in mind, let’s break down what the Indicator means and how you can use it to your advantage.
Table of Contents
What Is The Buffett Indicator?
Does Warren Buffett’s #1 indicator predict market crashes? The Buffett Indicator or the market cap to GDP ratio tells us how expensive or cheap countries publicly traded stocks are at a given point in time.
We use it as a broad way of assessing whether a countries stock market is over or undervalued compared to historical averages.
Typically the Buffett Indicator averages around 75% with a few spikes over 100% and some periods below 50%. In light of this, you can see why people are ringing the alarm bell. Does Warren Buffett’s #1 indicator predict market crashes? And how do you calculate it?
Buffett Indicator = Value of all public stocks in a country/The countries gross domestic product.
What Is Market Cap?
You’ve likely heard the term market cap thrown around, especially if you watch finance shows like MadMoney or BNN. is defined as the total market value of all outstanding shares.
To calculate, simply multiply the total number of shares by the present share price. Check out my example below of Facebook as of September 2021.
Current price as of closing September 17/21: $364.72
Number of shares outstanding: 2.83 billion
$364.72 * 2.83 billion = $1.032 trillion.
As it stands now, Facebook has a market cap of $1.032 Trillion. This makes Facebook the world’s 6th most valuable company by market cap.
What Is Gross Domestic Product (GDP)?
To explain it, let’s start with a standard definition of GDP, which is “the market value of all the final goods and services produced in a specific time period.”
Broadly speaking, it’s the meter stick of an economy and can be thought of as an overall grade on the economic report card of a country or region.
In other words, it’s one way to measure the size and growth of the economy. For example, if the year-to-year GDP of the United States is up 2%, this means that the economy has grown by 2% over the last year.
With this definition in mind, we can naturally assume that when the GDP is going up, the economy is said to be growing. Likewise, if GDP is slowing down or negative, it can be an early sign of troubles on the horizon.
Does Warren Buffett’s #1 Indicator Predict Market Crashes and Where the Buffett Indicator Stands Now
As of September 9, 2021, the Buffett Indicator stood at a mindblowing 241%!
Here’s how I calculated it:
Aggregate US Market Value: $55.1T
Annualized GDP: $22.9T
Buffett Indicator: $55.1T ÷ $22.9T = 241%
Shocking right?
Does Warren Buffett’s #1 Indicator Predict Market Crashes? Let’s Look
Does Warren Buffett’s #1 indicator predict market crashes? Take a stroll down memory lane, and you’ll see that the Buffett Indicator has a solid track record of predicting market downturns. Not only did it soar before the 2008 financial crisis, but it also went to the moon before the dot-com crash.
In a Fortune magazine article from December 2001, Buffett described his yardstick indicator as “probably the best single measure of where valuations stand at any given moment.” At this time, it was just after the dot-com bubble burst. The Oracle reminded us that the ratio rose to unprecedented levels in 1999, and “That should have been a very strong warning signal.”
Still, the Buffett indicator underscores the glaring disconnect between the stock market and the economy. With the S&P 500 and Nasdaq closing at record highs, with more than 57 million unemployment claims filed during the pandemic, there’s a disconnect somewhere. Does Warren Buffett’s #1 indicator predict market crashes?
The Indicator has proven very reliable if you turn back time—case in point, the 2001 and 2008 crashes. Prior to the house of cards falling, the ratio was in a nice uptrend. However, when the cards came tumbling down, so did the Indicator. I don’t want to imply that the Indicator is the only one you should be paying attention to, but if you’d picked your buys and sells based on the Buffett Indicator in those years, you’d have done well.
Criticisms
Does Warren Buffett’s #1 indicator predict market crashes? Like I’ve said before, there is no crystal ball that’s going to predict market moves. And the Buffett Indicator is no different.
Not only does GDP not account for income earned overseas, but US-listed companies also don’t necessarily contribute that much to the domestic economy.
Despite the accuracy of Buffett’s previous predictions, there are a few criticisms of the Indicator. First and foremost, it doesn’t take into account the state of non-equity asset markets. In reality, investors have a diverse portfolio with multiple asset classes (e.g. real estate, commodities, and corporate bonds, just to name a few).
At this point, I want to narrow in on the bond market which is, expressed as interest rates. Very generally speaking, bonds are a lower-risk asset class compared to equity (i.e. stock) markets. Furthermore, they have a highly interdependent, reciprocal relationship.
Nevertheless, the Buffett Indicator is far from perfect, but you should pay attention to it.
The Correlation Between Interest Rates & Stock Prices
Let me unwrap this for you by taking a 50,000 ft view on interest rates. High-interest rates mean bonds are paying higher returns to investors. In turn, this increases the demand for bonds and lowers the demand for riskier equities like stocks. Additionally, high-interest rates mean it costs a whole heck of a lot for businesses to borrow money to finance their growth. High-interest rates cut into a business’s bottom line and result in fewer profits. And again, fewer profits mean lower stock prices.
The opposite also holds true. Does Warren Buffett’s #1 indicator predict market crashes? Not neccessarily.
Low-interest rates mean poor returns on bonds, which lowers the demand for them. In turn, this raises stock prices in relation to bonds. Low interest rates make it easy for corporations to borrow money cheaply to finance plans for growth and expansion. With cheap rates come low corporate interest payments, making profits high. And this works the same way for you and me. With low interest rates, many consumers draw from lines of credit to finance home renovations, for example.
What I am trying to say is this: If interest rates are high, stock prices go down. If interest rates are low, stock price along with interest in them goes up.
Low Interest Rates = High Demand For Stocks & Higher Stock Prices
High Interest Rates = Low Demand For Stocks & Lower Stock Prices
Interest rates today are lower than they’ve ever been. Over the last 50 years, interest rates have averaged 6%. Back during the days of the .com bubble (when the Buffett Indicator was very high), the interest rate was higher than average at 6.5%. At this time, the Buffett Indicator was also very high. This tells us that it was just low interest rates juicing the stock market.
What’s Going On Today
Does Warren Buffett’s #1 indicator predict market crashes? If you look at a chart, you see that the Buffett Indicator is pretty much the same distance historical average as it was during the .com bubble. But, we have a glaring outlier: Interest rates are at an all-time low, pretty much teetering around 1%. What does this all mean?
Does this mean that during the dot com bubble, investors still piled recklessly into stocks even though they had other good options for their money? Whereas today, it wouldn’t make sense to invest in bonds because the returns are so little that you may actually lose money to inflation.
Are low interest rates forcing investors to invest in riskier, expensive assets like stocks? Perhaps yes.
Investors need to get a return somehow, and they’re looking to the stock market for it. Effectively, this pumps up the stock market, leaving us with wildly high runs. Now, this justifies why the Buffett Indicator is so high, but it may suggest the market might be less likely to collapse like it did in 2000. All things considered, it may stay abnormally high for as long as interest rates are abnormally low.
What are your thoughts? I’m curious to know; please leave a comment below.
