What Does The Buffett Indicator and Shiller P/E Tell Us?

The Buffett Indicator simply compares the total market capitalisation of U.S. stock market to U.S. gross domestic product (GDP). In a nutshell, it measures the stock market to the economy. The underlying basis is that the economy or economic growth drives corporate profits. So stock prices cannot outpace economic growth indefinitely.

The U.S. stock market is now 150% of the economy, close to the highest in history. It is probably higher as Q2 shrinkage of the economy is not accounted for. During the 2008 meltdown, the Buffett indicator dropped to about 50%. It is perhaps too much to read into a single indicator.

Prof. Robert Shiller of Yale created the Schiller P/E as a measure of the market’s valuation. The Schiller P/E is a more reasonable market valuation indicator than the P/E ratio. Why? It eliminates fluctuations of the ratio due to variation of profit margins during business cycles.

The regular P/E uses the ratio of the S&P 500 index over the trailing 12-month earnings of S&P 500 companies. It is artificially low during economic expansions and companies have better profit margins and earnings. The converse is true in recessions.

Both indicators (Buffett and Schiller) are useful for investors to decide when they should explore investing in a market. Currently, with the U.S. economy in a tailspin, U.S. unemployment at above 13%, Buffett indicator above 150 and Shiller at 28, it is not exactly time to invest in the U.S. market.

References:

1. Shiller P/E – A Better Measurement of Market Valuation, Friday, 12 June 2020 (www.gurufocus.com/shiller-PE.php)

2. What the Buffett Indicator Tells Us About the Highest Market Valuation Ever, Charles Sizemore, 11 June 2020 (www.moneyandmarkets.com)