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Last week, we discussed the possibility that Warren Buffett was selling Apple stock due to its high valuation. Another reason for this could be Warren's preference for a specific indicator. Since its introduction in 2001, this indicator has been known as the Buffett Indicator. It calculates a country's equity market value (sum of all stocks' market value) divided by the gross domestic product (GDP) of the country. The average of this indicator from 1970 to today is 84%. The lowest value determined by this indicator was in 1974 at only 30.4%, while during the dot-com bubble in 1999, the level reached 155%. Currently, we are seeing levels above 200%, an all-time high for the indicator.

In essence, we are witnessing unprecedented levels of equity valuations. The concern with such high valuations is that we are essentially accelerating future earnings and incorporating them into the stock price today. It may feel rewarding now, similar to receiving all our wages for the next ten years in one go, but we must still work for those earnings or repay the excess. These elevated equity valuations likely represent prepayments on future earnings. Unless there is a remarkable surge in earnings growth for the S&P 500, these stocks will need to stagnate or decline significantly to align with the average valuation relative to GDP. To return the indicator to its long-term average around 85%, either GDP must more than double, or stocks must decline by 55% while GDP remains constant. Both scenarios represent the extremes of how this imbalance could be rectified. The most probable outcome is for stocks to remain stagnant or slightly decrease over an extended period, allowing GDP to gradually catch up and normalize equity prices.

If we were to enter a prolonged period of heightened inflation and increased interest rates, reminiscent of the 1970s and early 80s, we could potentially witness a drop from the current over 200% indicator to below 40%. This adjustment may require one to two challenging decades to reprice equities. I think we would be foolish to ignore Warren’s actions here.  That said, markets can stay over valued for a long time. 

What is driving these extreme valuations, especially in the largest stocks? New research is beginning to scrutinize the impact of passive investing. We will delve further into this topic next week.