The “Buffett Indicator”…A Path to Profit

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Posted by The Savvy Retiree on April 6, 2016 in Money Saving Strategies, Personal Finances

“How far that little candle throws his beams! So shines a good deed in a weary world.”
— William Shakespeare, The Merchant of Venice

When I first met Eric Fry, he was seated at the head of a large oak table in the editorial room of a fashionable Baltimore mansion.

Around the table sat a dozen or so of the keenest financial minds I’d heard of at the time—biotech insiders, commodity traders, options gurus, macro analysts, currency experts…

Also at the table sat…me.

After a while the general chatter died down and Eric took the floor.

“I see a few new faces in the room today,” he began in a confident, familiar tone. “So before we get stuck in, I thought we might just go around and, one by one, introduce ourselves to the group.”

It was only later, over a glass of wine at the post-meeting “debrief,” that Eric told me there was only one “new face” at the meeting that day.

Mine.

To tell the truth, I didn’t have an invitation to attend in the first place. In fact, I’d invited myself to this intimate gathering of experts and gurus…hoping to learn a thing or two and, on a long shot, maybe even offer my own editorial services…such as they were.

Thanks to the favorable collision of unlikely events, I was fortunate enough to work alongside Eric for the better part of the next decade.

I even moved from Baltimore to Manhattan to take a desk in his Downtown office, on the corner of Wall and Broad Streets. (Yes, I was THAT dedicated to learning more about finance that I would trade the one city for the other. Imagine!)

Eric was then, and is now, one of the sharpest individuals I know…both in the relatively specialized field of finance, and in that other, broader field, known simply as “life in general”

And so, it is with great pleasure, that I introduce Eric to you today. If it’s wealth independence you’re after—learning how to make, protect and invest your wealth—he’s your man.

In his guest essay, below, Eric shares with us a couple of indicators that tell him:

A. The U.S. market is best sold…and,
B. The “rest of the world” is better bought.

Of course, there’s more to it than just that. Here, we’ll turn the floor over to Eric. Please enjoy…

***

Buy The World
By Eric J. Fry

If you needed a reason to lighten up on U.S. stocks, the chart below should do the trick. Take a good, long look at it… We’ll wait.

Walden Graph

 

The chart shows the total market value (i.e., “market cap”) of all U.S. stocks, expressed as a percentage of U.S. gross domestic product (GDP). This calculation is called the “Buffett Indicator” and it is telling us that U.S. stocks are expensive…very, very expensive.

Mr. Buffett did not invent this valuation gauge, he merely praised it publicly. Back in a 2001 interview in Fortune, Buffett lauded this indicator as “the best single measure of where valuations stand at any given moment.”

It has been called the “Buffett Indicator” ever since.

According to this “Big Picture” valuation gauge, a stock market is relatively cheap whenever its market cap drops well below 100% of GDP. Conversely, a stock market is relatively expensive whenever its market cap climbs well above 100% of GDP.

At the stock market lows of 2009, for example, the market cap of all U.S. stocks plummeted to less than 60% of U.S. GDP. But today, the U.S. market cap soars around 130% of U.S. GDP, which is roughly double the average readings of the last 65 years. Interestingly, today’s reading is also the second-highest level this metric has ever reached during the last 65 years.

If you need a second reason to lighten up on U.S. stocks, take a look at the next chart. It shows that the price-to-cash flow ratio of the S&P 500 Index has soared to within a whisker of the extreme reading this indicator hit in 1999, just before stocks swooned into the deep bear market of 2000-2003. (“Cash flow,” in this case, means EBITDA, or earnings before deducting interest, taxes, depreciation and amortization. This profitability metric is very handy because it eliminates the impact of accounting decisions and protocols that differ from company to company and country to country.)

Walden Graph

 

Taken together, the Buffett Indicator and the S&P 500’s lofty price-to-cash flow ratio both suggest that the U.S. stock market has “decoupled” from underlying economic trends.

In the parlance of the investing industry, this sort of decoupling is called “multiple expansion”—a delightful process that enables share prices to soar, even when the underlying economy isn’t doing much of anything. Stock prices rise because investors become willing to pay ever higher prices for each dollar of earnings or cash flow. So, for example, instead of paying $7 for every dollar of a particular stock’s annual cash flow, investors decide to pay $8 per dollar of cash flow, then $9, then $10, etc.

Multiple expansion is fun. It makes stocks go up. But there is a dark side to extreme multiple expansion: It often precedes its evil twin, multiple contraction.

After all, investors can decide to pay lower multiples just as easily as they can decide to pay higher multiples…especially if a selling panic takes hold. That’s why multiple expansion is one of the flimsiest of all stock market foundations…and why it’s usually a good idea to tiptoe away from pricey markets.

Imagine, for example, that the spectacular U.S. stock market reverted to merely average.

If the S&P 500 index fell to its average price-to-EBITDA ratio of the last 35 years, it would drop more than 30%. The Buffett Indicator presents an even scarier prospect. If the U.S. stocks were to return to their average Buffett Indicator readings of the last 65 years, they would plummet more than 50%!

Bottom line: U.S. stock market valuations are extremely rich…especially when one considers that stock market valuations outside the U.S. are much, much lower than they are here at home.

Foreign stocks have not participated in the same sort of multiple expansion process that has powered U.S. stocks to such lofty levels.

Based on the Buffett Indicator, for example, the non-U.S. portion of world stock market capitalization totals only 80% of non-U.S. world GDP. This reading is well below the Buffett Indicator reading for U.S. stocks.

Walden Graph

Similarly, the current price-to-EBITDA ratio of the MSCI EAFE Index of international stocks is nowhere close to the S&P 500’s price-to-EBITDA ratio.

Walden Graph 4

Given the gaping valuation disparity between U.S. stocks and their foreign counterparts, we say, “Sell the U.S.; Buy the world!”

Specifically, we suggest selling short the SPDR S&P 500 ETF Trust (NYSE: SPY) and then buying an equivalent dollar amount of the iShares MSCI EAFE ETF (NYSE: EFA). This sort of pair trade is a classic “convergence trade,” which succeeds if the prices of the SPDR ETF and the MSCI EAFE ETF converge toward one another. (On the other hand, the trade would produce losses if the prices of the SPDR ETF and the MSCI EAFE ETF diverged from one another.)

Importantly, this sort of pair trade does not subject investors to “directional volatility.” In other words, it could succeed, even if global markets are falling, provided that the SPDR ETF falls more than the MSCI EAFE ETF.
That’s the sort of hedged position that could come in handy during the weeks and months ahead, especially if the market’s recent turbulence proves a taste of things to come.

Image ©iStock.com/Aslan Alphan

 

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