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The ‘Buffett Indicator’ is growing dangerously out of whack as the stock market rises

February 19, 2021, 2:00 AM UTC

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Since late January, three pillars of Wall Street have issued predictions for where the S&P 500 will end the year, and they’re all expecting a leap from the near-record close of 3931 on Feb. 17. If they’re right, big-cap stocks will advance from their current standing of highly overvalued to outrageously expensive. That’s the conclusion from one of the most honored metrics in the world of finance, what’s known as the Buffett Indicator. In a 2001 interview with Fortune, Buffett stated that the best measure of whether the market is over, under, or fairly priced is how the total market capitalization of all U.S. equities compares with national income.

As Buffett put it, “The ratio has certain limitations in telling you what you need to know. But it’s probably the best single measure of where valuations stand at given moment.” According to the Buffett Indicator, the valuations foreseen by the three prominent market strategists would put the S&P in territory that medieval cartographers might have labeled, “Here lie dragons.”

The most modest forecast comes from RBC, which expects that the S&P will add 4% from Feb. 11 to year-end, closing at 4100. Credit Suisse is looking for a nearly 7% rise to 4200, and Goldman Sachs is the lead pull, positing a 9.4% advance to 4300. 

Let’s see how the S&P 500 would register on the Buffett Indicator if the index reaches the Goldman target of 4300 by the end of this year. Buffett’s yardstick uses the value of all U.S. publicly traded companies. I’ve adapted it slightly to deploy the combined valuation of the S&P 500, whose members account for around 70% of the total. 

The idea behind the Buffett Indicator is that GDP represents how much the U.S. economy produces in goods and services this year: In other words, everything our companies produce and sell here in the U.S. The market cap of U.S. companies reflects how much they’ll earn far into the future. If that number becomes too gigantic, it’s a sure sign that investors are expecting unreasonably elevated profits in the future that won’t materialize. Why? Because to get there, corporate profits would need to devour such a huge part of the economy that they’d squeeze the share going to workers, as well as the capital investment inevitably needed to keep growing.   

As of Feb. 11, the 500’s total market cap stood at $33.13 trillion. The Congressional Budget Office expects GDP to rebound this year, edging past its 2019 level to $22 trillion. Hence, the S&P valuation equals 151% of GDP. This is already an extraordinarily big number. I reached that conclusion by running the numbers since 2000. The highest previous readings over those two decades were 124% at the close of 2019, and 122% at the peak of the Internet bubble in Q1 of 2000. Overall, the ratio has averaged 84%, and the median is 100%. 

By my calculations, long-term fair value stands about halfway between the two, at 90%. At a current reading of 151%, the S&P appears overpriced by 67%.

What would seem like a red alert doesn’t in the least faze RBC, Credit Suisse, and especially Goldman. If Goldman’s forecast of 4300 by year-end happens, the S&P’s total valuation will rise from $33.13 trillion to $36.24 trillion by year-end. Keep in mind that the goods and services the U.S. produces would be just a hair above their volumes two years earlier. The Buffett Indicator would rise from 151% to 165%. By that yardstick, stocks would be 83% overpriced. 

It’s possible that the S&P will get there, but it can’t stay there. Not even close. Labor will get a much bigger share of the pie going forward; rates will rise to swell interest on corporate debt; and more capital will flow into upgrades and expansion. Wall Street is living through an era of predictions we might call “The Great Extrapolation.” The Buffett rule implies that the longer the extraordinary can’t keep getting more extraordinary, the steeper the fall ahead.