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A question of valuation

Equity bears lately have been fond of calling attention to record-high valuation ratios. No wonder, since the price arrow for stocks has continuously been pointing upward year-to-date. By a number of valuation metrics such as the Warren Buffett Indicator, equity markets at the moment are indeed richly valued as seldom (or never) before. But valuation metrics have never been a reliable timing tool. Even Warren Buffett has recognized this by now.

 

The Buffett Indicator is in the red zone…

Stock investors apparently put the coronavirus pandemic behind them quite a while ago. Consequently, US equity markets have been climbing for months now like clockwork from one new all-time high to the next, and more and more European stock indices have also been setting new records lately. The rally naturally has further raised market valuations and has once again frayed tempers lately, at least among the notorious pessimists. One indicator particularly sticks out here: the “Buffett Indicator,” which has surged to an all-time high level. Named after legendary investor Warren Buffett, the eponymous indicator (in its original version) depicts the ratio between the market capitalization of the US equity market and the USA’s annual economic output. In a 2001 Fortune magazine interview, Warren Buffett himself described the indicator, which was subsequently named after him, as a universal valuation metric, saying “it is probably the best single measure of where valuations stand at any given moment.” And, in fact, back in those days, the indicator actually did flag the peak of the Internet and high-tech bubble at the turn of the millennium with ratio readings well above 100% and a high of around 155%. Today, the market capitalization-to-gross domestic product ratio in the USA stands well above 200%. Even if we adjust the Buffett Indicator for its rising trend in recent decades, it is still higher right now than it was in 2000/2001 (far more than two standard deviations above trend). The valuation ratio gets slightly better (read: cheaper) if one factors in the US economy’s potential growth rate or even the (very positive) growth forecasts for this year in place of the last available gross domestic product figure, which was depressed by the pandemic. But this amounts to little more than massaging the numbers for a mild cosmetic effect. So, does the Buffett Indicator sky-high in the red zone mean that the next bubble is on verge of bursting, as a many a bear wants to make us believe?

 

The sky’s the limit(?)

Hot, hotter, Buffett Indicator

Ratio of US equity market capitalization to US gross domestic product

Sources: Bloomberg, Kaiser Partner Privatbank

 

Today, the market capitalization-to-gross domestic product ratio in the USA stands well above 200%.

…and has its shortcomings

Only time will tell… Meanwhile, however, we at least have to acknowledge that the financial market world has indeed exhibited certain signs of overheating in recent weeks. The keywords in this regard range from cryptocurrencies and SPACs to WallStreetBets and GameStop. But whether this means that a severe market nosedive is now imminent or that markets more likely are about to take just a needed breather is another story. A high Buffet Indicator reading alone is probably an insufficient condition for a correction. In any case, this indicator has considerable shortcomings on closer examination. They start with the indicator’s absolute value. The fact that it fluctuated around the 100% mark in the USA for 70 years, which makes that look like a “key” level from a purely numerical aesthetics perspective, may ultimately be entirely due to coincidence. At any rate, Buffet Indicator readings in other countries range from 30% for Italy, 66% for Germany and 286% for Switzerland to as high as over 1,400% for Hong Kong. This means that there are no universally applicable or “international” indicator levels for categorizing markets as being cheaply, fairly or expensively valued.

 

Pricier than during the Internet bubble

More than two standard deviations above trend

Buffett Indicator (normalized) and 10-year US Treasury yield

Sources: Bloomberg, Kaiser Partner Privatbank

 

What the Buffett Indicator also fails to take into account is the surrounding macroeconomic climate, particularly the interest-rate level. At the turn of the millennium, 10-year US Treasury notes yielded around 6% and were thus a serious alternative to shares of blatantly overvalued dot-com companies (most of which did not have a sustainable business model). Today, in contrast, the benchmark 10-year Treasury yield still stands below 2% despite having risen significantly over the last half-year. Bonds thus continue to be unattractive relative to stocks. Market interest rates play an important role from yet another perspective as well: the continual downward-trending interest-rate level over the last 20 years has lowered interest expenses for corporations and has made conditions for financing growth cheaper. This, in turn, has contributed to higher profits, which ultimately also justify a higher valuation, not just as measured by the Buffett indicator.

 

The cause of the rise in Buffett Indicator readings lies in a sustained rise in stock prices amid a climate of stagnant economic growth.

An academic take on the Buffett Indicator

Meanwhile, the Buffett Indicator has also found its way into the world of academia. Dmitry Kuvshinow (Pompeu Fabra University) and Kaspar Zimmermann (University of Bonn) extensively analyzed the correlation between market capitalization and economic activity in industrialized countries in a discussion paper published in December 2020. They come not just to the conclusion that the rise in Buffett Indicator readings is a global phenomenon observable over the last 20 to 30 years, but also posit explanations for this phenomenon. Their study shows that the cause of the rise in Buffett Indicator readings doesn’t lie in increased stock issuance or new stock-market listings (contrary to what one perhaps might presume), but is instead attributable to a sustained rise in stock prices amid a climate of stagnant economic growth. The increase in stock prices was driven by a profit shift in the form of a marked rise in publicly traded companies’ earnings as a share of both gross domestic product and capital income. The authors assert that the existence of this profit shift is consistent with the broader trend of increasing market power wielded by large companies and an increasingly uneven distribution of corporate earnings in the USA and worldwide (“the winner takes all”).

 

Only seemingly expensive? 

Rising profits arguably mitigate the lofty valuation (to a degree)

Forward price-to-earnings ratio for the S&P 500

Sources: Bloomberg, Kaiser Partner Privatbank

 

Valuation metrics are a poor timing tool

Warren Buffett has since acknowledged the shortcomings of the indicator that bears his name. He, in any case, has toned down his assertions from 20 years ago, and even he no longer likes to endorse any single valuation metric as being all-encompassing or consistent over time. In fact, nary a word about today’s conspicuously high market valuations was mentioned in the latest letter to the shareholders of his investment vehicle Berkshire Hathaway. But other valuation metrics such as the price-to-sales ratio, which likewise is at an all-time high in the USA, also aren’t beyond all doubt. The price-to-sales ratio, for example, doesn’t reflect the fact that companies have continually expanded their profit margins in recent years and thus pocket significantly more earnings per unit of sales these days. The well-known price-to-earnings (P/E) ratio remains the most sensible of the many valuation metrics out there. At a current level of around 24x, it too is close to where it was during the aforementioned 2000/2001 bubble period. However, there is a legitimate hope that the P/E ratio will moderate at least a bit in the quarters ahead if companies continue to trounce analysts’ earnings estimates to the same extent that we have seen some of them do in recent weeks. But in any event, one can hardly make an accurate prediction about the equity markets’ upside potential for the next 12 months on the basis of the P/E ratio. The P/E ratio gains predictive power on a five-year or, even better, a ten-year forecast horizon. On that timeline, a high present valuation implies lower returns in the future. From this perspective, stockholders arguably have to content themselves with lower returns over the next decade. But this doesn’t mean that stocks don’t have further upside potential over the next 12 to 18 months.

 

No near-term predictive power 

The longer the time horizon, the greater the relevance of valuation ratios

Forward price-to-earnings ratio and S&P 500 1-year returns

Forward price-to-earnings ratio and S&P 500 10-year returns

Sources: Bloomberg, Kaiser Partner Privatbank

 

Oliver Hackel, CFA Senior Investment Strategist

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