Investors Ignore Buffett’s Favorite Valuation Measure

The US economy is struggling through its worst decline since the 1930s. Corporate earnings have plummeted, and numerous CEOs are refusing to offer forecasts for upcoming quarters. Nonetheless, the major stock indexes have rallied to or above all-time highs. Investors appear willing to disregard weak fundamentals so long as the Federal Reserve continues to produce copious amounts of new money. Confidence appears strong that the Fed remains willing and able to step in to prevent any appreciable market decline. To the extent that such confidence remains, market prices have no ceiling.

For prices to rise much higher from here, however, historic limits of overvaluation will have to be broken. Legendary value investor Warren Buffett has described his favorite measure of valuation to be stock market capitalization relative to the size of the economy. The excellent Ned Davis Research service has measured that ratio from the mid-1920s to present. At the end of July, the estimated value of 3,800 US common stocks was 171.5% of nominal gross domestic product, the highest ever reading for that measure in the near century-long history of the study.

A review of the entire study shows seven prior ratio peaks that exceeded a level of 69%. All preceded substantial stock market declines, some from which it took more than a decade for prices to return to former highs. The following table shows the depth and duration of each decline, the date when prices initially regained their pre-decline level on both a price only and total return basis, and the latest date at which prices remained below their pre-decline level.

There have been no ratio peaks above 69% after which stocks did not decline substantially. It is noteworthy that the current reading of 171.5% is the highest ever level of overvaluation and twice that of 1929’s peak level. Of course, we can’t know that this ratio level is in fact the peak of the current rally. Investor enthusiasm engendered by Fed support could lead market prices higher still. It’s instructive, however, to recognize that broad market investments made at even far lower levels of overvaluation have always seen prices ultimately decline below purchase levels, even if they should rally higher first. For prices to continue to climb without a major decline, we would need to experience a realization of the financial world’s four most dangerous words: “This time is different.” Such an outcome is theoretically possible if the Fed is willing to abandon any semblance of financial discipline and simply inflate asset prices of all types.

Investors continue to be faced with the dilemma that has confronted them for years. Do they cast their fate with a Federal Reserve that has successfully promoted market advances for more than a decade, or do they rely on measures of fundamental value that have always ultimately been rewarded? Whichever outcome prevails, the effect on investors’ financial wellbeing will be profound.

By Thomas J. Feeney, Chief Investment Officer, August 17, 2020