Economic Indicators
Episode 300 of "David Has No Idea What's Going On"
In a similar vein to the name of this newsletter, economic signs and indicators are a useful tool for knowing where the heck you’re going. We’ll take a look at two economic indicators today, one from the infallible Warren Buffett himself, and the other from a Nobel Prize winner in Economics.
For those of us who are woefully ignorant, Warren Buffett, pictured above, is perhaps the greatest investor of all time. He’s the CEO of Berkshire Hathaway, a holding company for the likes of Geico and Fruit of the Loom, and a prominent philanthropist.
To date, Mr. Buffett has donated at least $40 billion to various charities, and created The Giving Pledge, whereby participating billionaires pledge to give away at least half their net worth to philanthropic foundations.
Mr. Buffett’s net worth?
$80.5 billion.
Besides being particularly good at what he does, Mr. Buffett also gives those good grandpa vibes. High on our checklist of good grandpa qualities is, “Simple quotes that are annoyingly profound.”
Observe:
“Someone’s sitting in the shade today because someone planted a tree a long time ago.”
“It’s only when the tide goes out that you discover who’s been swimming naked.”
“The most important thing to do if you find yourself in a hole is to stop digging.”
Mr. Buffett also has some quirky, lovable qualities that lend a sense of humanity to his otherwise deified persona. For example, he gets breakfast at McDonald’s every morning, and orders based on the random amount of spare change that his wife digs up for him. He also drinks Coke like a camel, and is still healthy as a bull at 90 years old.
In the investing community, Mr. Buffett has some serious clout. So, when he comes out and says an economic indicator is, “probably the best single measure of where valuations stand at any given moment”, you pay attention.
The Wilshire GDP
The Wilshire GDP Ratio is a long-term valuation indicator for stocks, and the subject of Mr. Buffett’s praises.
The ratio consists of the Wilshire 5000, which is an index of the largest 5000 companies in the stock market, over the US GDP. The Wilshire 5000 measures the total market cap of its comprising companies, which is the total dollar market value of a company’s outstanding shares of stock.
The market cap, in other words, is found by multiplying a company’s total number of shares outstanding, by the current price of one share. If Apple has 4 million shares of stock, valued at $100/share, its market cap is $400 million.
So, the total market cap of every company in the Wilshire 5000, divided by the current US GDP works out to be a good indication of the total stock market being historically overvalued or not. In short, it’s an indication of how much US production is being accurately reflected by the stock market.
In the past, if the valuation ratio fell between 50 and 70%, the market was considered moderately valued. The market is fair valued at 75 to 90%, and moderately overvalued between 90 and 115%.
The historical view is interesting:
The ratio has exceeded the 115% range of being moderately overvalued on several occasions. Most notable, the dotcom bubble of 2000, where the ratio weighed in at 159.2%, and this year, where we’ve oscillated between 125 and 155%.
Though less noticeable, the financial crisis of 2008 also checks into the overvalued category, at ~118%.
Why is this significant? The two most recent major stock market crashes came when the Wilshire GDP Ratio was historically overvalued.
The market is currently at its second-highest valuation in history; does this mean a correction is imminent?
One would think.
The Shiller PE Ratio
The second economic indicator is the Shiller PE Ratio. Created by Robert Shiller, a professor of economics at Yale and a Nobel laureate, the ratio is another insightful indicator of valuation in the market.
Shiller’s ratio is a comparison of price to earnings across the companies within the S&P 500. Rather than finding a static ratio over the last year, Shiller’s formula is cyclically-adjusted for the last decade, to get an average look at price to earnings of a stock and account for inflation.
In 1999, Shiller used his ratio and correctly argued that the market was heinously overvalued.
The ratio reached a lofty value of 44 in 2000, 30 in the Great Depression, 27 in 2008, and as high as 33 in 2019. Historically speaking, the market is significantly overvalued.
Both indicators have foretold financial unrest accurately, and look poised to do so again.
For the last few weeks, I’m pretty sure I’ve flip-flopped between whether I think the market will crash or not.
Apologies for the whiplash, but I think that’s probably the same situation for any financial pundit right now.
The next few months of Coronavirus treatments and the presidential election likely promise some interesting market disturbances, so stay tuned!
Thanks for reading :)