Research Assessment 5

Name: ​Sanya Maini

Teacher: ​Mr. Walters

Class: ​ISM 2

Date: ​Oct 18, 2019

Buffett Indicator: The Percent of Total Market Cap Relative to Gross National Product? Oct.

2019, www.gurufocus.com/stock-market-valuations.php. Accessed 16 Oct. 2019.

The Buffett Indicator

Even with the commonly held notion that the stock market is full of uncertainty, skeptics

are certain that Warren Buffett makes the correct decisions in the markets. Thus, it’s no surprise

that the Buffett Indicator is one of the most accurate and reputed measures to analyze the health

of financial markets. The Buffett Indicator measures the percentage of total market capitalization

(TMC) relative to the US Gross National Product (GNP). TMC is the market value of a

publicly-traded company's outstanding shares, the company’s stock held by shareholders. In

other words, market capitalization is equal to the share price multiplied by the number of shares

outstanding. GNP is the total market value of goods and services produced by the residents of a

country, even if they’re living abroad, whereas GDP is simply the total market value of goods

and services produced within the borders of a country.

The reason this TMC/GNP ratio is so effective is that it measures how overvalued the

market is: a ratio from 75% to 90% indicates the market is fairly valued, a ratio under 50%

indicates the market is overvalued, and a ratio above 115% indicates the market is significantly
overvalued. To put things into perspective, our current ratio is at 141.6%. This further proves my

previous conclusion about stock buybacks causing the apparent demand to seem high than it is,

meaning that there isn’t enough wealth in circulation since companies are heavily investing in

their own stocks. When the market is being overvalued, there are higher chances of an economic

downfall for the same reason.

An essential concept in the article was that in the long run, stock market valuation,

calculated by the Buffett Indicator, reverts to its mean. A higher current valuation leads to lower

long-term returns in the future since the market will drop at some point to the mean. Thus, a

lower current valuation level correlates with a higher long-term return. This conclusion is

evidence of the concept of market volatility that I have researched previously. This idea stated

that investing a lump sum over a long period of time will be more beneficial than investing

periodically since no matter the order of the years of returns, the average return-on-investment

will be around 8%, the average growth rate of the market. Using this information, we can use the

Buffett Indicator to predict whether the markets will rise or fall; currently, since the TMC/GNP

ratio is extremely high, analysts are using the indicator to predict a downfall.

Every time the ratio in the Buffett Indicator has exceeded 100%, the ratio has fallen

drastically. In fact, this occurred near 2001 and 2008, coinciding with the recessions in both

these time periods. This strengthens the conclusion that this indicator is a strong way to assess

and predict the future of financial markets.

Until now, I had thought that the downfall in the market was speculation. However, this

article explicitly states that the stock market is likely to return -1.9% a year in the next 8 years,

indicating that the research conducted is so precise as to predict the percentage of decline in
stocks. After learning what concepts and indicators push analysts to predict a downfall, I would

like to research how analysts determine the magnitude of the decline, which would require more

specific tools.