Apart from Buffett, is his indicator losing prestige as well?
According to Warren Buffett, it is one of the best indicators in the world: the Warren Buffet indicator named after him, which is also known as the ‘Total Market-Cap to GDP Ratio’. That indicator reached a record level of 151 percent on Friday. Usually, a reason to step out. But not this time, even his disciples say.
Buffett speaks of ‘probably the best measure to assess where the valuation level of shares is at the moment’.
The measure, which compares the total market capitalisation of all listed companies in the US with the gross domestic product, would, according to history-based textbooks, underscore that a ratio of more than 115 percent indicates a ‘significant overvaluation of equities’.
A range between 90 and 115 percent indicates ‘modest overvaluation’, between 75 and 90 percent indicates ‘fair value’, between 50 and 75 percent is ‘slightly undervalued’ and below 50 percent is ‘significantly undervalued’.
History shows that around 1982 the market was ‘extremely undervalued’ and in 2000 ‘extremely overvalued’. At the end of March of that year, an all-time high of 159.20 percent was achieved. The indicator then rocketed down until it reached the interim low of 71.30 percent on 2 March 2003. After that recovery began to 106.80 per cent on 30 October 2007.
However, as a result of the US housing market crisis and investment banks that needed to be rescued, it fell sharply again until it reached the 51.90 percent mark on 20 March 2009. That was the moment for investment veterans like Mark Mobius to shout that ”this is a once in a lifetime opportunity”. Mobius was right: the bull market that was in place at the time is now in its eleventh year.
Against the background of the long-term chart, it comes as no surprise that the 89-year-old Buffett remains so close to the meaning of this measure that he values so highly: American listed companies would – on average – be far too expensive. Berkshire Hathaway remains predominantly on the sidelines, leaving more than $130 billion of cash burning in his pocket.
Yet Warren Buffett finds himself increasingly critical of this conviction, even among his apostles. For example, hedge fund manager Bill Ackman recently withdrew his investment in Berkshire because he had been persuaded that Buffet’s investment vehicle remained so passive when it hit an interim low in March 2020. Ackman said he knew a better destination for his investors’ money.
The reason is that investors are mainly looking at future cash flow, and thus at company profits. In that context, Edward Yardeni, a well-known US economist and president of Yardeni Research, recently wrote that corporate profits in the US are bottoming out. As a result, expectations for profits in 2020 are being revised downwards at a faster rate than before 2021, which also means that next year’s profit expectations are becoming more meaningful.
Focus on 2021 earnings
Yardeni thinks that’s a good sign. He writes with reference to the experience of the Great Financial Crisis that the profits bottomed out eight to nine weeks after the turning point of March 9, 2009. According to him, this is now the case again, which means that the recovery of corporate profits could start this month.
Referring to the recession of 1990-1991 when the S&P bottomed out two quarters earlier than profits, he argues that the index reached a record low on 23 March, meaning that corporate profits could recover at the end of September. Against this background, it is not surprising that equity markets have started a new rally, especially if the US labour market creates 2.5 million new jobs in a single week.
This raises the question as to which stock market funds are flourishing best in such an environment. There is consensus among equity analysts that the corona crisis with its lockdown is accelerating the digitization of the economy and business extremely fast. The weight of FAANGM shares in the S&P is growing against the cliff to more than 25% of the total market capitalization. No less important, however, is the fact that other technology stocks are now also showing extreme price returns, thanks to very strong cash flow and profit figures.
At the same time, the weight of energy companies, banks, airlines, tourism, and the hospitality industry as a sector weighting in the indices has declined sharply. This offers opportunities for a (short-term) sector rotation in favour of these shares.
Example: while Buffet sold all its shares in American Airlines in March, these companies are already booking double-digit price gains on the stock exchange. This also applies to Boeing and Airbus, while energy companies have attracted the interest of bargain and dividend hunters. This is because the k/w ratios are extremely low, making dividend yields one of the highest on the entire stock exchange floor, at 4 percent.
The canary in the mine remains the corona crisis. If the virus became virulent again this autumn with many infections and deaths, which many virologists take into account, then there’s no telling where it’ll stop. Authorities could impose a new lockdown, which would force companies to report sharply lower profits and hit through their reserves. In that case, company closures and mass dismissals would be the result. Investors will then run en masse to the emergency exit, making a very deep crisis inevitable.