On April 25, the Bureau of Economic Analysis (BEA) released its preliminary estimate of the United States gross domestic product (GDP) for the first quarter of 2024. It estimated U.S. GDP at $28.28 trillion, up 1.6% from a year ago .
For the most part, this report is of interest to economists and institutional investors, and not closely watched by retail investors.
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But perhaps retail investors should pay attention, because GDP is one component of a potentially powerful stock market valuation metric: the Buffett indicator.
What is the Buffett indicator?
The Buffett indicator is the ratio between a country’s total stock market capitalization — that is, the value of all stocks listed on all exchanges in that country — and the size of its economy, as measured by GDP.
The legendary value investor Warren Buffett uses the indicator to gauge the priciness of a country’s stocks, by comparing the value of its stock market to the value of the actual economy underlying that stock market. In that respect, the Buffett indicator is kind of like a price-to-earnings (PE) ratio, but for countries.
Buffett developed the indicator in the aftermath of the 1990s dot-com bubble. This was a period when tech stocks, driven by early-internet-era hype, took on inflated valuations relative to actual economic activity before crashing back down to Earth in the early 2000s. At that time, in a quote now widely referenced, he said that the ratio was “probably the best single measure of where valuations stand at any given moment.”
In a US context, the Buffett indicator is often calculated by dividing the Wilshire 5000 index (a big-tent stock market index that contains almost every stock listed on a US exchange) by the GDP numbers provided by the BEA.
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Is the Buffett indicator high or low right now?
At the time of writing, the Buffett indicator reads about 182% for the US — meaning that the stock market cap of the US (as measured by the Wilshire 5000 index) is slightly less than twice its GDP (as measured by the BEA).
That’s pretty high, historically speaking. The long-term average value of the Buffett indicator is a bit less than 100%. So the current reading, in the absence of any other context, implies that US stocks are overvalued.
But Jared Dillian, editor of the Jared Dillian Money and Daily Dirtnap investment newsletters, says that investors should be wary of using the Buffett indicator as a market-timing signal of when to get in or out of the stock market.
“I think it’s kind of useless for timing,” Dillian says.
How should investors use the Buffett indicator?
Dillian says the Buffett indicator can be useful as a way to find undervalued stocks in overlooked foreign markets.
“It does give you an overall sense of valuation on a country-by-country basis,” he says.
International investing may entail more risk than domestic investing, and may not be right for everyone. But with so many foreign-stock exchange-traded funds (ETFs) and index funds available to US investors, getting international exposure has never been easier.
