Giuseppe Sandro Mela.
Theory & Data.
The Buffett Indicator is the ratio of total US stock market valuation to GDP. Named after Warren Buffett, who called the ratio “the best single measure of where valuations stand at any given moment”. (Buffett later walked back those comments, hesitating to endorse any single measure as either comprehensive or consistent over time, but this ratio remains credited to his name). To calculate the ratio, we need to get data for both metrics: Total Market Value and GDP.
Total Market Value.
The most common measurement of the aggregate value of the US stock market is the Wilshire 5000. This is available directly from Wilshire (links to all data sources below), with monthly data starting in 1971, and daily measures beginning in 1980. The Wilshire index was created such that a 1-point increase in the index corresponds to a $1 billion increase in US market cap. Since inception that 1:1 ratio has drifted, and per Wilshire, as of Dec 2013 a 1-point increase in the index corresponded to a $1.15 billion dollar increase. We adjust the data back to inception (and projected going forward) on a straight-line basis to compensate for this drift. For example, the Sep 2020 Wilshire Index of 35,807 corresponds to a total real market cap value of $42.27T USD.
For data prior to 1970 (where Wilshire data is not available) we use the Z.1 Financial Account – Nonfinancial corporate business; corporate equities; liability, Level, published by the Federal Reserve, which provides a quarterly estimate of total market value back to 1945. In order to integrate the datasets, we index the Z.1 data to match up to the 1970 Wilshire starting point.
Combined, these data make our Composite US Stock Market Value data series, shown below. Our estimate of current composite US stock market value is $52.0T.
The Gross Domestic Product (GDP) represents the total production of the US economy. This is measured quarterly by the US Government’s Bureau of Economic Analysis. The GDP is a static measurement of prior economic activity – it does not forecast the future or include any expectation or valuation of future economic activity or economic growth. The GDP is calculated and published quarterly, several months in arrears, such that by the time the data is published it is several months old. In order to provide updated data for the most recent quarter we use the most recent GDPNow estimate published by the Federal Reserve Bank of Atlanta. The GDP data is all nominal and not inflation adjusted. Our estimate of current (annualized) GDP is $22.6T. A historical chart of GDP is shown below.
The Ratio of the Two.
Given that the stock market represents primarily expectations of future economic activity, and the GDP is a measure of most recent economic activity, the ratio of these two data series represents expected future growth relative to current performance. This is similar in nature to how we think about the PE ratio of a particular stock. It stands to reason that this ratio would remain relatively stable over time, and increase slowly over time as technology allows for the same labor and capital to be used ever more efficiently.