First, you gotta read Warren Buffett’s classic piece from 1999:
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:
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.”
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:
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.And here are some summary stats from 4/1/1947 to 10/31/2013:
- 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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