The formula is very simple, a multi billionaire and the head of Berkshire Hathaway foundation Warren Buffett introduced it in 2001 when he was asked by journalists about the best criteria to consider if the market is functioning at very high levels. It could be said that it is a way of looking at the value of all stocks on an aggregate level, compared with the economy's total output.
According to TeleTrade analyst José Maria Castro Monteiro (https://www.teletrade.eu/pt), public concern about this indicator is heightened at the moment, because it came very close to the level of 150% in 1999-2000, shortly before the collapse of the dotcoms, and then again soared well above 100% before the financial crisis of 2008, each time falling down to lower levels between 50% and 70% along with the fall of market indices. Buffett himself mentioned that the need to cool the market may be very actual, in sync with the approach of this ratio to 150%, or even more so to 200%, when the situation is becomes more and more alarming.
To estimate the ratio of the capitalization of the whole Wall Street to the real size of the U.S. economy, one can take Wilshire 5000 Total Market Index, which exceeded the value of $46.7 trillion before the end of August. At the same time, the GDP of the United States for the second quarter of 2021 was $22.72 trillion, according to the latest estimates. Dividing the first number by the second, anyone can easily get the value of the Buffett indicator over 205% and start blowing the whistle.
But, is the market situation so dangerous, in fact, and could it be true that one more end of the financial world is knocking on the door?
The Warren Buffett indicator has already exceeded the level of 150% twice in 2018 and 2019, but nothing terrible happened during those periods. Perhaps, even a temporary crash would not have happened in 2020 too, if not for the global distribution of the coronavirus.
It could also be logical to assume that more than 4.5 trillion Dollars thrown into the financial system by the Federal Reserve (Fed) as part of quantitative easing from 2009 to 2015 significantly raised the average and the highest bars for providing money supply to the markets, and automatically moved a previously critical values of the Buffett criterion to an "updated" higher level. Almost a dozen trillion of Dollars and Euros in total from the Fed and the European Central Bank (ECB) in 2020-2021 may set this bar even higher, up to some "new normality" epoch level of much more than 200%.
TeleTrade analyst considers that, the financial world is facing an unprecedented moment of ultra-high inflation expectations and is acting accordingly. Big funds and smaller companies plus private investors are seeking protection from the inflation-based devaluation of cash money's purchasing power. Excessive investments into stock markets could be considered as not just emotional moves, but a reasonable and preventive measure.
Here is an example. If a hamburger suddenly starts to cost $20 tomorrow in the U.S. cities, then people would eat about the same amount of burgers or even less burgers to keep some money, but both the revenue and profit of McDonald's would formally rise, as would the value of its shares, even though this higher sum of money would not actually have more value than the current stock quotes of McDonald's.
The Buffett indicator, reflecting the ratio of market capitalization to GDP, would certainly recover to more adjusted lower values again, but not due to the collapse of the stocks. Instead of the market falling to the U.S. GDP or global GDP levels, a formal but inflation-based rise of the GDP of many states may happen. The larger size of GDP could be expressed in relatively devalued both dollars and euros, but this does not mean that all of us, or citizens of the United States, Australia or other countries, will start to live a better life.
José Maria Castro Monteiro
Market Analyst & Business Developer