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The Buffett Indicator is at record highs, signaling the stock market may be overvalued.
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Yet, research from Morgan Stanley highlighted two flaws in the Buffett Indicator’s methodology.
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Changes in global sales and digitalization challenge traditional stock market valuation methods like the Buffett Indicator.
With the stock market trading at record highs, Warren Buffett’s favorite valuation indicator is also hitting new peaks.
The Buffett Indicator, which measures the total market capitalization of US stocks relative to US GDP, hit an all-time peak of about 209% on Monday, surpassing the record high of 200% reached in August 2021.
In other words, the US stock market’s total market cap of about $61 trillion, as measured by the Wilshire 5000 index, is more than double the annualized US GDP of about $29 trillion.
Bearish investors have been quick to point to the Buffett Indicator as yet another signal that the stock market is significantly overvalued and due for a correction.
Yet, research from Morgan Stanley suggests the gauge may not be the best valuation tool to follow.
Michael Mauboussin of Morgan Stanley’s Counterpoint Globlal highlighted two flaws in the famed Buffett Indicator, which Buffett introduced in a 2001 Forbes article.
“The first is that U.S. companies now get more of their sales from outside the U.S. than they did in past decades. GDP does not include those sales. That means the numerator, market capitalization, reflects a larger addressable market than what the denominator, GDP, captures,” Mauboussin said.
The gauge’s failure to capture foreign sales is a big deal, considering that about 40% of revenues derived from S&P 500 companies come from international markets. If those revenues were encapsulated in US GDP, then the Buffett Indicator wouldn’t be flashing as big of a warning sign as it is today.
The second flaw concerns the idea that the economy today is much different than it was in past eras.
“Second, GDP is arguably understated because it fails to measure accurately the quality of goods and services as well as the value of new goods and services. The rise of digitalization makes measurement today more challenging than in the past,” Mauboussin said.
Whereas the GDP-based stock market valuation indicator may have proven more accurate decades ago, when manufacturing was a bigger part of America’s economy, that’s not the case today.
Research from BlackRock and economist David Rosenberg recently has echoed this thinking.
“The equity market’s changing sectoral composition reflects the transformation taking hold. So, comparing today’s index to that of the past is like comparing apples to oranges,” BlackRock said last week.