Guided Investor

The Buffett Indicator | Does it apply to Australia and it is relevant during COVID-19

Warren Buffett is basically a rock star of the finance world. He is a self-made billionaire and at the ripe of old age of 89 he is still the CEO of Berkshire Hathaway which is a highly successful investment company. When Warren Buffett speaks, we listen.

Back in 2001 Buffett said that the ratio of the market value of all listed securities to GDP, or more simply put the size of the share market relative to the economy, is “probably the best single measure of where valuations stand at any given moment.” This ratio has since been referred to as the ‘Buffett indicator’.

It is said that if the stock market is below 50% of the GDP, it is too low. Between 75% and 90%, the market is about right. Above 115%, it is overvalued on a relative basis. Well Buffett indicator is currently sitting right around 144% which is the highest it has been since 1970.

Although this chart refers to the US stock market and the US GDP figures it is still highly relevant for us here in Australia as the US represents the biggest economy in the world and whatever happens in the US, we tend to follow along for the ride. If we look at Australia’s version of the Buffett index it paints a similar picture however we don’t currently have any 2020 GDP figures for Australia yet so we can’t really factor in current events.

So the Buffett indicator is telling us that stock markets are overvalued and this is probably the reason that Warren Buffett himself is currently holding $137 billion in cash at Birkshire Hathaway. In fact, the only significant move he has made to date during the current downturn is to sell a $4 billion holding in airlines.

So is the Buffett indicator correct, is the market over-valued? The short answer is yes, I do believe it is currently overvalued HOWEVER, and this is a big one, you can’t ignore the significant stimulus that has been pumped into the markets.

Sure, economic growth is slowing and we are likely headed into a recession. But the share market price is not determined by economic activity it is ultimately determined by supply and demand for stocks.

We are seeing companies who have had a 50%+ cut to their profits yet only trade at 20% discount to their share price in February. This doesn’t make sense from a fundamental perspective but can be explained by the fact that demand for stocks is still high due to the incredible level of stimulus we have seen recently. It is basically like having inflation in stock prices.

In addition to the money being pumped into the share market from fiscal stimulus we are also experiencing record low interest rates. If you hold your money is cash you are probably earning less than inflation. This is a sure way to lose wealth slowly over the long-term. So people are eager to get back into the market.

Also, let’s not forget that economic data is backward looking and share prices are forward looking. So with economic data falling and share prices remaining strong (for now) this might just simply suggest that people expect the impact of COVID-19 to be short-lived.

However, despite all this I do think that fundamentals will win out in the long run. Like Buffett, I remain cautious. I think the economic hangover from COVID-19 is going to be significant and that needs to be reflected more in share prices before I get too excited with my cash!

But of course, this is just speculation. I wouldn’t make the bold move to sell out of all my holding based on speculation just like Buffett has only sold out of one sector which has been hit with the full force of COVID-19. For now, I continue to accrue new cash and wait for an opportunity.

To finish this one off, let me leave you with a quote from Buffett at his recent shareholder meeting for Berkshire Hathaway:

“I’m not saying that this is the right time to buy stocks if you mean by ‘right’ that they’re going to go up instead of down. I don’t know where they’re going to go in the next day, or week, or month, or year. But I hope I know enough to know, well, I think I can buy a cross section and do fine over 20 or 30 years. And you may think that’s kind of, for a guy, 89, that that’s kind of an optimistic viewpoint. But I hope that really everybody would buy stocks with the idea that they’re buying partnerships in businesses and they wouldn’t look at them as chips to move around, up or down.”  

Disclaimer

The information in this website is for general information only.

It should not be taken as constituting professional advice from the website owner – Guided Investor as Authorised Representative of Symmetry Group (AFSL 426385)

You should consider seeking independent legal, financial, taxation or other advice to check how the information relates to your unique circumstances.

Guided Investor is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this document.

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