Rational Exuberance

In a piece penned in MarketWatch on Halloween entitled “Warren Buffett’s favorite market metric suggests investors are playing with fire,” Shawn Langlois claims that Warren Buffett’s favorite stock market indicator is currently in dangerous territory. In fact, the measure was nearing levels only witnessed prior to the bursting of the tech bubble in 2000.

The Buffett indicator is the total market capitalization of all U.S. stocks relative to the country’s gross domestic product. That metric stood at a lofty 139 percent, which is perilously close to the record 145 percent it hit immediately prior to the bursting of the dot-com bubble in 2000.

In a Fortune article in 2001, Buffett wrote that when the value of all stocks is 80 percent or less than the size of the economy, “buying stocks is likely to work very well for you.” He added, “If the ratio approaches 200 percent -- as it did in 1999 and a part of 2000 -- you are playing with fire.”

The reason for this high valuation, according to the Daily Reckoning’s Jody Chudley, is the explosion of passive index funds and ETFs. In essence, Chudley says that “these passive vehicles buy the exact same stocks with no thought whatsoever given to valuation.”

It sounds like prudent investors should be selling stocks and raising cash, or does it?

Simply looking at one indicator without proper context can be very misleading. In an interview with CNBC’s Becky Quick in February of this year, Buffett made the case that stocks may “actually be on the cheap side compared to historic valuations.” The Oracle of Omaha went on to explain that the reason for his position was the low level of interest rates. Buffett explained that “if interest rates were 7 or 8 percent then these prices would look exceptionally high.”

Stocks and bonds compete for investor’s dollars. The current yield on the ten-year U.S. Treasury is a paltry 2.43 percent. Essentially, the ten-year Treasury is selling at a PE ratio of 41. All of the sudden, a PE of 25.5 on the S&P 500 does not look so outrageous, given both bright corporate earnings prospects and a likely reduction in the corporate tax rate. With over half of the S&P 500 companies reporting so far this earnings season, analysts forecast that when it is all said and done earnings will have risen about 8 percent.

The current stock market valuations are not driven by passive investors, but by low interest rates and corporate earnings. What could, and likely will, precipitate a market decline is a substantial increase in interest rates, and that decline could be exacerbated should the rate increase be unexpectedly rapid. For clues about the direction of the stock market, investors should monitor the bond market. Rising interest rates are bad for stock investors. In Invest With The Fed (McGraw-Hill, 2015), Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I found that from 1966 through 2013 when rates were rising, the S&P 500 only returned 5.9 percent annually. In contrast, when rates were falling, the index returned 15.2 percent annually.

As the late Paul Harvey famously said, “now you know the rest of the story.”

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