The «Buffett indicator» is a very simple but one of the best stock market indicator to value stocks. It is so simple because it relates the capitalization of the entire stock market to the GDP.
But this metric indicates that the valuation for the US market is currently very high. Even though stock prices have fallen sharply this year, the Buffett indicator is still close to 1.6. That’s significantly higher than even during the dot-com bubble. Historically, this hasn’t been a good time to buy stocks. The expected return for the next 10 years is less than 2%.
But how reliable is this indicator really?
Studies confirm that the Buffett indicator performs excellently and outperforms another commonly used metric, the Shiller P/E. The Shiller P/E uses price relative to earnings over the last 10 Years.
Returns to be expected over the next 5-10 years are relatively very low or even negative. A crash is possible to adjust stock prices to the economic output. Investors who need their assets within the next 5-10 years should consider to position themselves defensively and/or should reduce the exposure and proportion of equities in their portfolio. The passive long term investor should be patient and start to invest when the stock market corrects and offers better opportunities for positive returns.
Sven Franssen