The Theory Behind the Warren Buffett Indicator
If the total market capitalization is too low, the capital in the economy will move into stocks and stock prices will rise as the country is creating a lot of output and has excess money to invest. On the other hand, if the stock prices are high compared to the GDP, the country is not strong enough to continue future investments in the stock markets at the current level. The Buffett indicator therefore is showing the ability of an economy to generate earnings and returns to investors.
How to Interpret the Warren Buffett Indicator
The Buffett indicator can give you three interpretations. The market can be prices too low, about right or too high. If the stock market is half the value of the GDP the stock market is undervalued (50%). If it is between 75% and 90% of the GDP it is about right and if is more that than 130% it is overvalued.
Is the Buffett Indicator a Sign for a Crash?
By the interpretation of Warren Buffett the Buffett indicator is not a sign that the market will crash. The main meaning is that long-term investments at an overvalued market are not expected to give positive returns. At 130% Buffett says the return is about -1.5%. However, the indicator must always be seen compared to other investments that are currently possible and also be viewed according to the country that is being investigates. In some countries there might be less companies at the stock market which can influence the proportions of the indicator.
The following chart shows that the indicator is not necessarily a sign for a crash but also that in the recent years it was.
How Can I Personally Use the Buffett Indicator?
For your personal interpretation, you can use the Buffett indicator to
- You can use the indicator to assess the current general market condition.
- You can use the indicator identify countries which are undervalued and determine the according investments.
- The indicator can also be used in order to analyze sectors. Therefore, adjustments have to be made based on historic data. The percentage values have to be adjusted to make an according assessment.
An up-to-date data for the Warren Buffet Indicator can be found here.