Decoding Valuations Using Buffett Indicator

This indicator is suggesting overvaluation of Indian markets →

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Today in less than 5 minutes:

1) Are the Indian markets overvalued?
2) Stock in Spotlight: A real estate company where promoters, FIIs, & DIIs have increased their stake
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Are the Indian markets overvalued?

The best single measure of where valuation stands at any given time is measured by the Buffett Indicator.

Warren Buffett

Think of the stock market like a glass of water and the economy's size as the glass's capacity.

If the water level (representing the total market value of all publicly traded stocks) is high compared to the glass's capacity (representing the size of the economy), it means the market might be overheated or overvalued. On the other hand, if the water level is low compared to the glass's capacity, it suggests stocks might be undervalued or there's room for growth.

The Buffett Indicator helps us see if the glass is too full or not quite filled up enough in relation to its size.

Let’s learn how its value is calculated…

Calculating the Buffett Indicator

Buffett Indicator = Total Market Capitalization of all publicly traded stocks / Gross Domestic Product (GDP)

Total Market Capitalization is the total market value of all publicly traded companies within that country's stock market.

Gross Domestic Product (GDP) is a measure of the total value of all goods and services produced within a country's borders during a specific period. It’s like the total amount of money earned by everyone in a neighborhood over a year.

For example, in 2015, the total market capitalization was $1.8 trillion while the gross domestic product (GDP) was $2.2 trillion.

Hence, the Buffett Indicator = 1.8/2.2 = 0.81

So the Buffett Indicator was 81% in 2015.

Interpreting the Buffett Indicator

To determine if the market is overvalued or undervalued, look at the Buffett Indicator over a long period, say 10-20 years. Compare the current value of the Buffett Indicator to the average value over that period. If the current value is higher, the market is considered overvalued and if it is lower, it is undervalued.

We examined the 10-year performance of the US markets.

The following conclusions were derived:

  1. When the Buffett Indicator's value is way higher than usual (more than 2 standard deviations), the market tends to fall a lot.

  2. If the indicator’s value is between 1 and 2 standard deviations, there are usually corrections in the market. So, be cautious.

  3. If the market goes below -1 standard deviation, it's considered a good time to get into the market.

Applying a similar logic, we analyzed the trend of the Buffett Indicator for Indian markets:

Currently, the Buffett ratio (95%) is above the average Buffett ratio of the last 10 years (80%), which shows that the market is in the overvalued zone.

Note that there are other ways to interpret the Buffett Indicator, and several other ways to analyse stock market valuations as well. This indicator should form just a part of your overall valuation analysis.

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