By |Published On: November 5th, 2013|Categories: Uncategorized|

First, you gotta read Warren Buffett’s classic piece from 1999:
http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

Buffett highlights the inextricable tie between GDP growth and corporate profits. GDP growth is the limiting factor (interest rates and margins are the other factors).

And here is his follow up in 2001:
http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/

Recently, there have been a spat of articles related to macro valuation signals and the stock market. Many of these articles talk about “Buffet’s favorite valuation tool.”

An example:

Why is Market Cap / GNP considered Buffett’s favorite? He said so…

“…probably the best single measure of where valuations stand at any given moment.”
–Warren E. Buffett from 2001 Fortune article

Gurufocus has a great article on the topic and some associated tools:
http://www.gurufocus.com/stock-market-valuations.php

Below is a chart of the Market Cap to GNP ratio since 1952 along with associated 5-year rolling percentile bands to indicate times of “excess.”

We are able to extend the ratio past the Wilshire 5000 data via CRSP, and you can also recreate a proxy via market-cap breakpoint data from Ken French’s

website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

Data on GNP/GDP only goes back to 1947 so we can’t do better than that.

Currently, the ratio stands at 1.224x.

Microsoft Excel - mc_gnp

[Click to Enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

And here are some summary stats from 4/1/1947 to 10/31/2013:

179

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Key takeaways?

  • Expensive, but not unprecedented.
  • Broke the rolling 5-year 95 percentile breakpoint.
  • Mean reversion to long-term mean of .70 would imply SERIOUS market drawdowns.

But what are the alternatives? 2.5% 10-year treasuries?

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

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Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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