The Buffett indicator is a metric measurement of capitalization to GDP (Gross Domestic Product) ratio. The ratio or the Buffett indicator is easy to calculate. To calculate the Buffett indicator value, add the total values of the stocks of the U.S. market (U.S. market cap or TMC). Then divide the sum with the GDP of the United States. Warren Buffett popularized the metric calculation, and the name is in honour of him.
The formula of the indicator: [Buffet indicator = Total Market Cap / GDP of nation *100]
Warren Buffett is the guru of investing in stocks. He stands in fourth place among the richest people in the world. Many businessmen and investors follow his principles of investment and stocks. Business schools also teach their financial rules. Warren Buffett called it the best single proportion of where valuations remain at any random second. The Buffett indicator is his favourite stock market indicator.
How To Interpret The Ratio Or The Indicator?
The Buffett indicator is similar to the cost-to-sales ratio, but for a nation. The price divided by the sales gives the measure of valuation. The expenses divided by the sales ratio of more than a hundred per cent considered as an indication of being overvalued. The ratio under below fifty per cent indicates cheap value. We have to interpret the Buffet indicator in the same way. This indicator evaluates the entire country instead of just one company.
To analyze the Buffett indicator quickly, remember a few rules: when the total stock market is under fifty per cent of the GDP, it is low. When the Market Cap is around seventy-five to ninety per cent of the GDP, the stock market is in the right phase. Overestimation of stocks occurs when the sum of stocks over 115 per cent of the GDP. Higher the Buffett indicator higher are the chances of the market being in the over-valued territory. The higher Buffett indicator signifies market correction. The World Bank discloses the Stock Market Capital to the GDP of the entire world. The indicator was 55.2 per cent at the end of 2015.
Don’t Just Depend On The Buffet Indicator. To Know More About Other Investment Techniques, Click Here!
How Does The Buffet Indicator Help?:
- It helps to analyze the market trend of a particular stock over the years.
- The indicator helps to predict the market bottom or bear market.
- It portrays trends of valuation.
- Investors can invest when the prices are low by using this indicator.
- It is easy to calculate, even for the new investors.
- We can easily calculate the trends and stock value of markets.
- Markets of all the nations use it.
- Fund managers around the world use it to decide whether to enter or exit the stock market.
- The indicator indicates the market highs and lows as well as volatility of the stock market.
- Investors can take the warning of the stock market bottom earlier using this indicator.
- The correlation between the indicator of the good deals and market crash is high.
What Are The Factors Affecting The Buffett Indicator?
Initial Public Offerings(IPOs), as well as the percentage of organizations that trade publicly in comparison to the private ones, can influence the total value of stocks to the GDP. The GDP will increase even if the public or private companies increase.
Can We Use Buffet Indicator In The Indian Context?
The indicator saw an increase of over a hundred in 2007 and 2018. In the year 2007, the indicator represented 147, and in the year 2018, the indicator represented 103. In both the years, the Indian stock market noticed market corrections. Buffett indicator thus gives an idea about the Indian market as well. Hence, it is a good indicator of stock market corrections even in India.
There a few limitations to the indicator when used in the Indian context. Fifteen per cent of India’s GDP is from the agricultural sector. Stocks do not represent them. Capitalization of market stocks does not account for a lot of private companies. Small and medium scale industries and the output from them is not listed in the stock market. These unlisted contributions are not calculated, which can give an error.
The Buffet indicator did not exceed a hundred per cent except during the period of recession (2007-2008). Many of the sectors that contribute to the GDP of India are not listed, when noticed on the Bombay Stock Exchange (BSE). However, we can take the averages of the indicator in India and use it as the level instead of 100 per cent. Economists consider the Indian average to be seventy-five per cent.
Drawbacks Of The Buffett Indicator :
- A few economists criticize the indicator as a renamed price to sales ratio.
- The indicator does not consider changing tax rates.
- We cannot take into account the unlisted contributions to GDP. The unlisted companies are a few private companies, partnerships, government departments, etc.
- In the year 2003, the indicator was nearly 130 per cent. Usually, the per cent would indicate an overvalued market. But, the stock market produced all-time highs in the coming year.
- Many financial experts believe that using Gross National Product (GNP).
- One cannot always depend on this value.
- There have been new indicators that are suitable for recent and changing economies.
- It is a better indicator in the developed nations like the United States, Germany, Singapore, Sweden, and the United Kingdom.
The Buffett indicator warns a greater market crash than the Dot-com bubble or the recession of 2007. The indicator already indicates a stock market. Warren Buffet claimed that the indicator reached a point insisting him to sell stocks. Currently, we are at the level of 135 per cent, which is higher than a hundred per cent. This indicates that the market is overvalued. The Coronavirus pandemic has increased and al=dded to the market crash and overvalue.
All the investors need to look at a complete picture rather than just the Buffett indicator. Have an idea about all the other indicators. It is important to evaluate the right time to buy and sell stocks based on your instincts after taking up suggestions.