I briefly touched upon the Buffett Indicator — market cap to GNP — in an earlier article but wanted to go into further detail, as it will be at the core of this long-term project.
It is my understanding that Warren Buffett first touched upon the idea of the Buffett Indicator in a 2001 Fortune article titled, Warren Buffett on the Stock Market. The article is a must-read for every value investor as Bufett talks about investing, interest rates and, of course, market valuation. When talking about the Buffett Indicator, he said, “Still, it is probably the best single measure of where valuations stand at any given moment.”
With that sentence alone, the Buffett Indicator was born and took on a whole new level of popularity in the world of finance.
What is the Buffett Indicator?
As the article describes it, the Buffett Indicator is a market valuation ratio. It is not a predictor. It simply allows you gauge whether the stock market is overvalued, fairly value or undervalued at any given time. It is comprised of two components: market capitalization (Wilshire 5000) and the country’s Gross National Product (GNP). While Buffett uses the indicator for American markets, you can calculate this ratio for every country as long as you have the data.
So where do you find the Buffett Indicator?
All of the data is available at the Federal Reserve Economic Data website. I did this quick YouTube video to guide you through the process of calculating the Indicator.
But thanks to several free websites, the indicator is now available online without you having to do any manual calculations.
How do you use the Buffett Indicator?
Keep in mind, the Buffett Indicator is simply a market valuation tool. It is not a predictor of what the stock market is going to do. In 2017, we have learned that an overvalued market can remain overvalued.
“Consistently buy an S&P 500 low-cost index fund.” – Warren Buffett, CNBC March 2017.
Some simple bit of advice from the Oracle of Omaha. Yet not too many follow it. And if they have, not too many have documented it. So I set up this website to document a simple strategy around the Buffett Indicator and the one rule that dictates Warren Buffett’s buying: “Be greedy when others are fearful, and fearful when others are greedy.”
Starting in 2018, I set up an account with TD Ameritrade. I also set up automatic deposits of $75. I know it’s not much now, but it is a super long-term project.
The goal of this project is to build long-term wealth by consistently buying a low-cost index fund.
The Buffett Indicator comes into play by telling me how much to buy. If the market is overvalued, I buy a little bit and let my cash build up. When the Indicator gets below 80%, historically, it has been a good time buy. It is that simple! Yet most will not follow these guidelines.