Warren Buffett says if you buy stocks at these levels, you’re “playing with fire.”
Dov Marshall, CFP, CLU, CIM - Investment Advisor and Portfolio Manager
I help high-net-worth Canadians avoid the rollercoaster of the stock market while achieving great investment returns.
The ratio of market capitalization to GDP is also known as the Buffett Indicator. In a December 2001 FORTUNE Magazine interview, Warren Buffett said that the ratio is useful for gauging the stock market's overall valuation.
Conceptually, investors price stocks based on expectations of future corporate earnings, which depend on future GDP growth. Over long periods, market capitalization should scale with GDP because corporate earnings are a subset of GDP. Therefore, it makes sense that the stock market’s growth should align with the country's economic growth, as measured by Gross Domestic Product (GDP) or Gross National Product (GNP).
Buffett stated: “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.”
As we currently stand with the equation exceeding 200%, it is appropriate to evaluate these ideas carefully.
Is This Measurement Still Relevant?
One of the more significant questions raised about this method of evaluating the stock market is that the structure of the market has changed over time in two key ways:
International Revenue Exposure1980s-1990s: U.S. companies began expanding their operations internationally, but the majority of their revenue remained domestically sourced. Precise data from these decades is limited, but international revenue exposure was relatively modest compared to later years.
2000s: Globalization accelerated, and by 2010, nearly 40% of the market-weighted sales of S&P 500 companies were from international markets. Between 2000 and 2010, approximately 40% of earnings growth for these companies originated from international markets, with some years seeing this figure as high as 60%.
2010s: The trend of deriving significant revenue from abroad continued. By 2014, the international business exposure of S&P 500 companies had evolved substantially.
2020s: In recent years, the share of foreign sales has remained substantial. As of 2023, foreign sales made up 28% of the S&P 500's revenue. The Information Technology sector had the largest exposure, with 59% of its revenue coming from foreign sources.
From the 1980s to the present, S&P 500 companies have significantly increased their international revenue exposure, reflecting broader trends in globalization and multinational expansion. This raises the question of whether domestic GDP growth can still be considered a fair measure for the increasingly intercontinental U.S. stock market.
Now to the second change. Increasing Profit Margins.
Over the past 40 years, the net profit margins of S&P 500 companies have fluctuated significantly, influenced by various economic cycles, technological advancements, and market dynamics.
1980s-1990s: Net profit margins for S&P 500 companies averaged around 6% to 8%. The economic expansion and technological innovations of the 1990s contributed to gradual margin improvements.
2000s: The dot-com bubble burst, and subsequent recession caused a decline in profit margins in the early 2000s. However, margins began to recover in the mid-2000s, reaching approximately 9% before the 2008 financial crisis, which again compressed them.
2010s: Following the Great Recession, net profit margins experienced a significant rise. In the decade after the recession, margins reached all-time highs of around 15%, compared to a historical median of 9%.
2020s: Profit margins have remained elevated in recent years. For instance, in Q3 2024, the blended net profit margin for the S&P 500 was 12.0%, slightly below the previous quarter's 12.2% and the year-ago figure of 12.2% but still above the 5-year average of 11.5%.
Overall, the long-term trend indicates that net profit margins for S&P 500 companies have increased over the past four decades, rising from 6-8% to around 12%.
Higher profit margins justify higher valuations. Can we still use the same measuring stick as in the past?
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The Fundamental Comparison Issue:
A third point regarding the Buffett Indicator's methodology is the fundamental difference in how these two numbers—market capitalization and GDP—accumulate over time:
GDP (Denominator) is an annualized economic flow measure. New economic activity adds to GDP each year, effectively "resetting" it annually. GDP represents the sum of all goods and services produced in a given period.
Market Capitalization (Numerator) is a measure representing the cumulative value of equity markets, building on past valuations. Market cap reflects both the retained earnings from past years and future expectations.
This raises an important question: How can we compare these two numbers when one (GDP) resets each year while the other (market cap) accumulates over decades?
Each year, a portion of national income (GDP) is invested into the stock market, and those investments compound over time. While new investment activity comes from new GDP income, the stock market itself has been built on prior years of accumulated investment profits.
Each year, retained earnings from prior years are reinvested back into the stock market. So, it would make complete sense that if the stock market was fairly valued at one times GDP in the year 2000, by the time 2025 comes around, it should be at a much higher number, maybe even 250 percent of GDP, which, as mentioned, is not cumulative at all.
A Global Perspective
As a side note, the World Bank publishes the global market capitalization of publicly listed stocks as a percentage of world GDP. According to the latest reported numbers, this figure stands at 105%.
Given these factors, investors should critically assess whether the Buffett Indicator remains an appropriate tool for evaluating market valuations in today’s economy.
Sources:
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3 周Great topic!