Buffett’s Secret Ratio Explained for Investors (and Beginners)

Warren Buffett said years and years ago that you get this ratio or you get this percent, and if that percent's low, stocks are undervalued, and if that ratio is high, then they're overvalued.

Market capitalization to GDP. For the average person that's self-managing, I would say this is a great tool for them.

How can someone who is contributing to a 401k utilize the Buffett indicator to better position themselves?

And we have so many headwinds right now around the globe. If we don't get it under control, it's going to be felt in asset prices. They're going to deflate. Period.

The Buffett indicator is extremely high. Should I stop investing?

Welcome back to another episode of We're Talking Money. I'm Spell and I'm here with Phil.

Thanks for having me.

I know that I'm an unfamiliar face on the show. Happy to be here. But today we're going to talk about something that the pros talk a lot about, and that is market capitalization to GDP. So, Phil, what the heck is that?

Yeah, there's so many rules out there and there's so many ratios that the pros use. We use them. Our portfolios are managed with some of these very things that we're talking about. And the last couple of weeks we've talked about other ratios. So the CAPE, which was created by Robert Shiller, that's a good one, and it's really looking at price to earnings in a different way. And we looked at forward P/Es, so forward multiples.

And now we're talking about something that's been around for a while. Warren Buffett, arguably the best investor in the world. They call him the Oracle for a reason. The guy's done it and he did it well. He said years and years ago that if you took the total market cap, and we used the Wilshire 5000 to measure that, if you take that market cap and you divide that by the GDP, or gross domestic product, you get this ratio or you get this percent. And if that percent's low, then he said stocks are undervalued. And if that ratio is high, then they're overvalued. And either of those or something in the middle warrants a closer look at your valuations to be sure that you're not buying things when they're too pricey or that you're missing opportunities when they're cheap.

Yep. Yep. Warren Buffett is a household name. No doubt. And if you don't know him, you're not paying attention.

That's true.

And this metric or data that we're looking at, it's been named after him. Right?

That's right. It's called the Buffett indicator, right?

Right.

It was his little creation, so to speak. Now, it's been tweaked by plenty of people.

Sure.

We still use the classic, which is Wilshire 5000 divided by GDP. Pretty simple.

So, Phil, you mentioned that this is something that we're using. We use the Buffett indicator in our charting and our analysis. For the average investor, put that into plain English. What does that mean? Because we talk a lot about things that a lot of times go over most people's head. So, put it into plain English for me.

Yeah. So, first, it's not a timing tool, and that's what most people want. Everybody wants a timing tool so they know when to buy and when to sell. Well, there's nothing like that, right? There's nothing that's a perfect timing tool, and the Buffett indicator certainly is not an exception to that. So, it's not timing. What it is is more of a gauge to remind you that stocks can get overvalued, they can get undervalued, or they can be somewhat neutrally valued.

The way we use it is really more of a wind sock. So it's what direction is the current moving: are stocks overvalued or are they undervalued? And so for example, if that indicator right now being at close to 200, and it's been much higher than that in the last six to eight months, okay, and it came down a little bit, not nearly enough to say that stocks are properly valued, but now it's rising again. And what that means is it came down back in April when we had the market selloff. Now it's rising again because what happened? All of a sudden, tariffs came off and everybody said, "Oh, let's pile back into the market because this is probably another V-shaped recovery." And so far, that's what it's been, right?

So, we look at this not as a way to say get out of the market. We look at it in terms of do we want to add more exposure to those large cap names or midcap or small cap, whatever they are. Are we overvalued? Do we want to look at other places around the world? Do we want to look at foreign investments now versus domestic? Because remember, this is the entire market, but it's mostly looking domestic. Okay. So it helps us there. Or if the market's way undervalued, is it a good opportunity to deploy cash and buy things while they are on sale?

Sure. Let me put this in maybe a different thread, if you will. Most people, working people, have 401ks, right? How can someone who is contributing to a 401k utilize the Buffett indicator to better position themselves?

That's a great question because so much, in fact, I was talking to one of the analysts at Bloomberg early this week and we talked about that very thing. Okay, I would say if you're that person, you don't worry about a rule or an indicator. You don't worry about Buffett or anybody else. What you do is you keep putting money in the market because you're dollar cost averaging. So when the markets are down, you're just buying more shares. When the markets are up, your dollar is going in, same amount, but you're just buying fewer shares. Over time, that's going to work out really, really well for you. So you don't worry about an indicator. You worry about trying to put the most you can in your 401k and get your match from your employer and maybe some profit sharing. That's what you worry about, not an indicator.

Got it. So 401k participants maybe need to focus more on something like dollar cost averaging, where they're putting money in every paycheck. They're deferring wages into a 401k plan or a 403b plan, whatever it might be. What about on the professional management side, where indicators maybe mean a little bit more?

Yeah. So, you got lots of people out there who are self-managing, and those are the people that we don't work with, and that's great. And those are the people that can use these kinds of indicators. Our clients trust that we're using these indicators the right way. And we have so many indicators. This happens to be one that gives us some ideas of an over/under in terms of valuation.

Mhm.

But for the average person that's self-managing, I would say this is a great tool for them. Again, not timing, and not to say that stocks are absolutely overvalued or undervalued, because remember, this ratio doesn't take into consideration interest rate environment, right? Doesn't take into consideration geopolitical things. None of that's considered. This is purely the market, market cap, all cap, and it's GDP, and that's it. And so it's a very, in my opinion, basic indicator, but basic works.

And this is for that person who's the average, or say the self-manager. They're taking this and they're using it as a way to say, "Look, stocks are really highly valued here relative to where they've been." And maybe it's time to raise a little cash. Maybe it's time to change my focus. Maybe I need to be looking at South Korea as an investable part of my portfolio. Not all domestic. Got it? Or maybe it's China. Maybe it's Brazil; right now it has great valuation. So whatever that is, this is the thing that would remind you to look at those other places because this looks highly valued. Today at 200%, I can tell you historically speaking that is way above where it should be in a good market.

What is normal? So 200% is certainly high.

Yeah.

What's normal?

150 is high.

Okay. So we're higher than—

150% is high. Yeah. 140%'s high. Now if we were, say, at 75% or lower, then I'd say, Spell, we need to be taking all of our dry powder and putting it in the market because stocks are undervalued.

Yeah.

But right now we can't say that by any metric, by the way, and certainly the Buffett rule is telling us that, but none of our indicators are saying that the market is priced with value in mind. Everything is overpriced at this point. I don't care where you look. We're way overvalued.

So is there a way that we can look at how the Buffett indicator has changed through history?

Well, we have a chart for it. We can look at it against the backdrop of, say, the S&P 500, but I think your question is great. Has it changed? No. It's broad market, total market divided by GDP. Doesn't change. It's the same thing every year. Got it? Here's what changes. Valuation, and people coming into the market, people buying because they're following the crowd, or people getting out of the market because they're following the crowd. That's what changes. So, that changes where that ratio is. It's 200, it's 140, it's 100, it's 75.

And so if you take 2020, for example, we had this little virus thing that came through our country, or around the world, and everybody just went bonkers. We closed the country and told everybody to put on your Halloween mask, and all of a sudden we had this situation where valuations fell like a rock. They did. We went into a recession, the shortest recession on the books. Right. So if you go back from the beginning of the markets, never had a recession last in such a short amount of time, right? So from that, the valuation, or the Buffett indicator, it went way down quick. And so it was sub-75.

Well, guess what? Everybody should have been buying that dip because that indicator clearly said we were way undervalued. Interestingly enough, because people follow the crowd, and this is why indicators are good, and it's why you need to learn to have your own rules if you're self-managing, people saw that happen, but they were so scared because the market fell 54% in a very short period. Nobody was buying, and they missed an opportunity of a lifetime to buy stocks that were on sale at that level. And so many people missed it; they weren't paying attention. But that indicator, the Buffett indicator, was telling you straight away this is a buying opportunity.

So speaking of paying attention, I think you bring a good point. The Buffett indicator, as you just mentioned earlier, is extremely high. Should I stop investing?

Well, that's a great question. So I don't think anyone should ever stop investing. I think you should be really aware of where you're investing. So, for example, do I think domestic stocks are overcooked here? I think they are. I don't know how valuations can go up. Here's what I'll tell you. I think if we can get earnings to go up by 30% between now and the end of the year, then stocks aren't overdone. Keep buying. That doesn't happen very often.

I don't know where you get 30% earnings growth between now and the end of the year when you've got an economy that is slowing, when you've got consumer spending that's going down, sentiment's not great, and we see little bits of layoff occurring. Not a lot. I'm still not too worried about that. Unemployment's not rising enough for me to be really cautious at this point, but the data is telling us that the economy is slowing. Interest rates are staying higher for longer. The Fed's supposed to lower twice this year. If that happens, maybe, but that's not a good outcome either, because that means people can start borrowing again if rates come down. The outcome to that's not good. And if they can't borrow, the outcome's not good. We're sort of in a position of you're sort of danged if you do and danged if you don't.

So it depends, but right now there are other places where you could find value. So if you wanted to keep buying, then I would say you need to be a little heavier weighted towards foreign things. But if you believe that a recession is in the cards, if you think that this economy is going to slow, I'd probably be stacking some cash. I'd be underweighting equities, holding some cash, buying some more liquid assets, because there's going to be an opportunity when markets will come down; you'll have a better opportunity to buy. I wouldn't be buying anything if you're on that side of the argument. Right? If you think a recession's coming, I wouldn't buy anything.

So, if we think a recession's coming, we ought to wait, or keep an eye on the Buffett indicator for that to come down. And then if we've stockpiled some cash, deploy the cash when the Buffett indicator reaches what?

If it's at 100, you ought to be buying. If it's at 120, or if it's coming down, then you've got an opportunity, and it's going to tell you. It's going to tell you. So, if that's the only indicator that you had, you could at least say, "Well, stocks look a little better value today. Maybe not perfect. More research has to be done before you just buy into stocks."

Sure.

But if all you had was the Buffett indicator, this is one that's tried and true. Again, doesn't consider interest rates and some of the other things, but it's still good. Baseline to look at our GD. And here's what it tells you, for those of you listening, if you hadn't figured this out yet: what it's telling you is that our GDP is not growing fast enough to reduce the ratio. And if our GDP is stagnant, that means that our country is not growing at a rapid enough pace to justify these out-of-sight valuations. And right now I think across the board valuations are way high.

And all you have to do if you really want to see what I'm talking about, that the large caps are higher than they should be.

Yeah.

It's hard to see it there because people say, no, the market looks good. S&P's going up, rallied hard after the April downturn. Look at small caps. Look at the small cap indexes and see what you find. They can't seem to get their footing. And that's all domestic stocks. And those are stocks that don't have the borrowing power of your large cap companies, your mega companies. They feel it.

And by the way, those indexes show exactly what I'm talking about. You can't ignore that if you're trying to figure out what you want to buy. Look at all of that and you can, you should be able to come to the conclusion of stocks are overpriced, but they will come down.

Yeah. Yeah. So, let me just make sure I get this right. Market capitalization is your numerator. GDP is your denominator, what you're dividing by. The more GDP grows relative to market cap staying the same, the smaller or lower your ratio becomes.

Ratio comes down. Yep. And if it comes down, you got buying opportunity potentially. But it also, here's what the Buffett indicator requires. It requires patience.

Sure.

Right. Warren Buffett probably has the greatest patience of any investor that any of us have read about and maybe ever will. He was never aggressive. He's always been patient. He's willing to wait. And because of that, he became one of the greatest billionaires of our time. Maybe one of the best investing success stories that we'll ever hear, right? Plenty of people are going to hit it big and make a lot. But Warren Buffett did it little by little and learned how to buy value and that's what made him so great.

I think that to your point is those numbers bring that ratio down. You just pay attention to that. But it won't happen fast.

Right. Right. We could stay elevated here for a while and as long as we do, you can play that trade if you're good at reading the markets and getting in and out. But if you want to be a long-term investor, then you have to believe that either our country, our GDP is going to grow you through all of this, or you have to be more strategic and only be willing to deploy your cash when this indicator is telling you that stocks are a better value.

Phil, what you're saying must be true because GDP as a data point is only released quarterly. So you can't get a true Buffett indicator until a GDP data point is published. So patience I think is a virtue. Unfortunately, most people want their money yesterday and they want their growth yesterday. We don't live in a patient society, do we?

Right? We live in a society where everybody wants instant gratification. They want instant purchase power. They want instant delivery. Everything has to happen now.

Or yesterday.

Exactly. Last year. Dang it. Hurry up. I just ordered something from Dick's Sporting Goods. Isn't it here yet?

So that's probably fly it in on the drone, right?

But that's the mentality that we have is everybody wants everything now and investing was never meant to be that. And then you've got things like Bitcoin and some of these other high-flyers that have made people really wealthy really quick. And that has exacerbated this problem of the instant gratification or the desire to have things in an instant, right? Investing was never meant to be that.

And I think today valuations are so high because of that. People jump into these trades and they ride them hoping that they're staying on the right side of the trade, but they're jumping in thinking they can get rich quick and some people will.

Well, think about the language that you just used and it's super important. And people are so quick to move beyond what someone says without actually thinking about it. You just used the word investing and you use the word trade. Those are not synonymous.

True.

Investing is a long-term approach, more of a buy and hold, if you will, and adjust subtly along the way. Trade is very rapid.

Right. Yeah, that's right. If you're trading, you better be really, really good. You've got to know where you're getting in, where you're getting out. And that's usually something that technical people are doing. They're using technical analysis for that or charting, right? And that's good. I love charting. I love technical analysis and I enjoy it. It's very, it's useful for sure, but it's not the only thing.

And particularly if you're looking long-term, if you're a long-term investor, you don't want to pay attention to technicals only, right? Fundamentals still matter. Even though today I'm hard-pressed to make that argument because fundamentals seem to be out the window, but if you're a fundamentalist and if you're someone who likes buying value, then you'll get what I'm saying. If you're someone who just loves the growth story, you might not like what I'm saying, but believe me right now that there have been periods across many, many time frames where the market got so overvalued, it will come down 100%.

It always reverts to the mean. This is no exception. And we have so many headwinds right now around the globe. If we don't get it under control, it's going to be felt in asset prices. They're going to deflate. Period.

Phil, all the information that you provided is great. I think it's going to be extremely useful, but I want to make it practical. So, I'm going to show a chart of this Buffett indicator, and I'd like for you to walk me through what you see when we look at this chart.

Yeah. Okay. So, all right. So first, let's go all the way back to 2008.

Okay.

Right. Everybody remembers the financial crisis. Notice before that we were in around at about the say 15 120% mark.

Yeah.

On the Buffett indicator. When we hit '08 and the market started coming apart and really they were still coming apart in '09. But look what happened. This Buffett indicator was down to around 70. That is a buying opportunity. And anyone in 2008 who was watching this kind of an indicator would have said, "I'm in." Because we're at an all-time low, for example. We can't show you any more of the chart, but that's what that would indicate.

Now, fast forward and hit 2021. Look at where we peaked. We were at 255. That's way up there. Crazy relative to all of these other periods. And then it fell to around 160 around 2020 2022.

Mhm.

And so at that point people are saying, "Oh, it must be a good time to buy." 160 is still high, Spell. That's still higher than we're comfortable with. So we didn't really see value there. So it became a real picker market. You had to stock pick based on real fundamentals, right? You couldn't just go off of this.

Now we see it going up again, and it's at 196 as of this reading. So, right at 200, that's way overdone. So, that tells me valuations are still high. Valuations are rich. I think they have to come down before I feel really comfortable deploying a lot of money here.

So, I'm going to do one of two things or maybe two of two things. I'm going to raise cash. I'm going to take some of the gains that I've been enjoying here as this market's been going up into the stratosphere unnecessarily really and unjustifiably. I'm going to peel some of those gains, raise some cash so I've got money to spend when this thing finally comes down. That's number one.

Number two, I'm going to look around the world and I'm going to figure out what asset classes are still properly valued. Some of those foreign plays that I talked about earlier where price to earnings multiples are 12 or 13 where America is trading at 27 28 times earnings. I'm going to go for value somewhere else until things here get a little bit better.

But if I think this country is going into recession, foreign always follows that. They don't go up when we're going down. So I'm probably, if I believe recession's imminent, I'm not buying anything right now, and I'm going to raise cash, peel off some of my gain, so I've got dry powder on the sidelines, ready to go when this thing comes down.

You must be talking about buying low and selling high.

That's at least the way it's supposed to be done, right? Yep, that's right.

Phil, thanks for walking me through the chart. It's super helpful. It's pretty illuminating actually to see what technical analysis can show us. Let's give our listeners some actionable things that they can utilize at home. Maybe they are self-managing. You mentioned self-managing. What's something that a listener should take away from what we're talking about today?

Yeah. Well, the first one is know why you're investing, right? You got to know why you're doing it. You're not just doing this for the heck of it. You're doing it because you're trying to grow your wealth. And so, you want to be careful with the way you do that. One, know why.

Two, you want to set goals. What are you trying to accomplish? How much money do you have to spend and what do you like investing in? If it's all domestic, got to really be careful here. But really, no matter where you like to invest, it's setting goals. And then as you're reaching those goals, reset them.

And then find indicators that make sense to you. If you're going to self-manage, find indicators, whether it's the Buffett rule, whether it's the CAPE, whether it's forward PE, whatever it is, and more than one. I think is a better way to do it. I don't think you should ever just manage based on one ratio, but figure out what you like.

Know what your goals are and then stick to your plan. Build your plan and stick to it and give it time to work. Staying in the market versus timing the market has been proven more times than I can count to be the right way to invest. So, okay, to trade some, sure, but just know what you're trying to accomplish. Build a plan, stick to it and then adjust, making incremental adjustments or small adjustments versus throwing the baby out with the bath water.

Yeah, got it. Phil, I know you have one more thought, but before we get to that, we've noticed that some of our viewers are not subscribed to our channel. So, we'd appreciate it if you would subscribe. We'd also appreciate it if you'd like this video. If you found value in this video, we'd appreciate it if you shared it amongst your friends and family and across your social media platforms even. So, Phil, one more thought.

Yeah, I think the Buffett indicator, great tool. It's not the only one. Just one in a list that we've been working on to share with you in these video series. It's not the only one, but it's one that you could use. Biggest thing that you got to take away from all of this is patience. Figure out the indicators that work best for you. Build your plan. Be patient. Stick to it. Don't expect the delivery of lots and lots of gains yesterday. It's going to take some time.

Now, if you're interested in learning about other indicators that we've been talking about that the pros use, check our comments section. We've got a list of them there. You can see what the series looks like and more is coming. So, please click on the screen or click in the comments section.