Warren Buffett, the greatest investor of all time and the one who everyone always likes to quote, customarily prices the market according to a very basic ratio – the ratio of the market value of all companies to the US GDP.
The market value of all US companies is the sum of the equivalents of all US public companies. GDP is the number of final sales/services provided in the US, increasing around 3% per year.
What is the connection between the two? Because GDP is growing, companies sell more, they grow, and then their values go up. Therefore, the market value of all American companies cannot be detached from GDP, and the growth of companies should be adjusted to sales growth. Therefore, it is clear that it makes no sense for the value of companies to go higher faster than their growth, which is reflected in the increase in GDP. Therefore, in a normal situation, this ratio is 0.9 (less than 1 since private companies and government investments are included in GDP).
Today, this ratio stands at 170%, meaning that American companies’ value is 70% greater than the GDP, which is well above the fair value. Just to give you an idea, before the dot-com bubble burst in 2000, this ratio was 160%.
So, according to the numbers and graphs, we are in a bubble market that is about to burst.
On the other hand, this ratio does not tell the whole story since GDP is not the only factor that drives the market upwards.
In the next post, we will upgrade this Buffett indicator and discuss another significant factor that causes the market to move upwards, well above GDP growth.