What The Buffett Indicator Is Telling Us

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In their latest episode of the VALUE: After Hours Podcast, Brewster, Taylor, and Carlisle discuss What The Buffett Indicator Is Telling Us. Here’s an excerpt from the episode:

Tobias: Speaking of Buffett, let me do the indicator. There’s really not much to this. The Buffett Indicator which I understood it to be total market cap to gross national product, which is all of the goods and services traded by companies that are domiciled in the US, including its national stuff and GDP is all of the trading that goes on inside the borders of the US, whether it’s owned by domestic corporations or external ones. As it happens, the distinction is almost irrelevant, because the two lines are virtually identical and have been for forever. It doesn’t matter.

This particular article or this paper, I don’t know whether it’s Master’s level or PhD. I don’t know what level of paper is, but they have said that gross domestic product rather than GNP, which is what I understood Buffett to be, but it doesn’t matter. GDP versus market value of equity MVE is quite predictive over 10 years, they get a very high R squared. The way that they do it is not cross-sectionally. So, you can’t compare one country to another country. So, you can’t say America is 158% of market cap to GDP and Germany’s 55% market cap to GDP. Therefore, Germany is cheap and America is expensive. That doesn’t work.

The way that they use it is they look at it relative to its own history. So, wherever your average is going back through the data, that’s your average. When it’s expensive relative to that average, that’s expensive. When it’s cheap relative to that average, that’s cheap. And so, it’s more predictive in CAPE. They say they couldn’t find any statistically significant support for CAPE, which I thought was pretty interesting.

Jake: We got a flag Meb on this one. Let’s see– [laughs]

Bill: No.

Tobias: I’ve seen other papers that say that CAPE works fine. Hussman in that tweet that I saw, there’s an attachment to a Hussman chart at the bottom where he shows the predictability of all of these different ratios. The one that he finds best is non-financial market capitalization versus gross profit. Oh, sorry– [crosstalk]

Bill: Okay. So, back out the banks and stuff?

Tobias: Yeah.

Bill: Okay.

Tobias: And then, he’s looking at profitability. He says that’s the most predictive at 90– It’s got a 0.91 R squared over a decade, 0.93 over 12 years. So, he uses a 12-year period. I don’t really understand why 12 is better than 10. But in all the research that I have seen, the longer you go out using CAPE, the more predictive it becomes. So, that’s probably the reason why.

The most interesting thing out of it though I thought was that there are certain countries where it’s not very predictive and I find that they’re mostly bank financed. I guess people take loans to start businesses instead of trying to raise money through equity. Bank finance nations haven’t traditionally had a very good fit for MVE to GNP, whereas countries like the States, Canada, Australia, England, there’s about 15 countries that have all got these very high R squared for those things.

So, I just thought was interesting. Buffett’s intuition on that was right and it’s probably a reasonably good metric just to bear in the back of your mind when we’re very, very expensive relative to our own long run average, you might want to be just mindful about what you’re sticking your shackles into.

Jake: Or at least temper your return expectations for the next period of time?

Tobias: Yeah, I think that’s fair.

Bill: It’s just so hard, because things have sold off so much that it’s like, “Well, is it priced in? Is it not?” This company I follow OEC, read their investor day, read their current earnings call. If the world doesn’t fall apart, it’s probably cheap. If the world falls apart, nothing’s cheap.

Jake: hmm. That’s very Yoga Bear, Yogi Berra.


Bill: Yeah, I think I’d have enough liquidity get through a couple years here. I wouldn’t want to be a force seller over the next three years.

Tobias: That’s right.

Bill: I never want to be, but you could [crosstalk] really fucked.

Tobias: You want to be getting longer here. I don’t think you can be pulling the shackles out of the fire anticipating the flush, even though I do think it’s going to happen. I’m just trying to mentally prepare for it. So, I don’t panic when it happens. Not that I can really do much damage panicking anywhere, but just for my own mental tranquility and peace.

Bill: I don’t know what happens on the backend to all this, because one of the things that I’ve said a lot is like– [crosstalk]

Tobias: Rips.

Jake: [laughs]

Bill: Yeah. Well, I don’t know what happens to housing, because look, I guess there’s some version of the world where all the Airbnb investment was malinvestment and it’s all this phantom inventory that comes on the market, I don’t actually think that’s true. I actually think that Airbnb is a very legitimate product and has given people a very legit income source. How those people are financed, whether or not they flip, whether not they can get through downturn, all that, I don’t know.

Jake: I think it’s sponsored by all the maids out there, because those cleaning fees are off the chain. [laughs]

Bill: Yeah, they are.

Jake: [crosstalk] financed by a big cleaning fee.

Tobias: [laughs]

Bill: Yeah. Well, it is unfortunate that we all can’t be subsidized by venture capital anymore. That was a nice time.

Jake: Yeah. That was fun. Uber rides for free.

Bill: Yeah, that was great. Shoutout to the VCs.

Tobias: [laughs]

Bill: They all got rich off it and left the public holding the bag.

Tobias: Teaches patience once again.

Jake: Yeah, always the last– [crosstalk]

Bill: [crosstalk] total bull shit like Robinhood.

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