How Warren Buffett Determines if a Market is Overvalued

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Warren Buffett—or the Oracle of Omaha—is widely considered to be one of the great investors of all time given his uncanny ability to pick stocks. While Buffett made his fortune investing in iconic U.S. brands like Coca-Cola and Gillette, the principals that he uses can be applied to any market around the world to help identify the best opportunities over the long-term. Many of these principles have been time-tested by other experts like his mentor Benjamin Graham.

When it comes to valuing an entire stock market, Buffet prefers to compare a stock market’s total capitalization with gross national product to determine whether it’s historically undervalued or overvalued. Buffett believes that a ratio of 70% to 80% yields a buying opportunity for stocks, while a ratio approaching 200% indicates a potential correction ahead over the coming quarters, as the market is likely overvalued.

Finding the Data

The World Bank provides a wealth of data for all countries around the world, including gross national product and equity market capitalization data points that can be used to create the market cap to GNP ratio. The organization even provides the ratio itself as a separate indicator for many different countries around the world, enabling international investors to quickly find the information they need for comparison.

When consuming the data, international investors should be sure to plot the data points or view charts to show movements over time. The simple reason is that no countries are identical and investors need context to decipher the meaning of these movements. For instance, the U.S. has always had a high ratio approaching 100%, but investors would have been unwise to avoid U.S. equities altogether, despite these seemingly bearish trends.

Investment Strategies

There are many different strategies that international investors can use with a market cap to gross national product data in hand. On the conservative side, many investors may want to use the indicator to identify starting points for value-driven equity research. On the riskier side, some investors may be interested in pursuing long-short strategies where they short-sell overpriced market and buy underpriced markets hoping for corrections, which is known as an arbitrage strategy.

When using the ratio, investors should keep a few things in mind:

  • Underlying Factors – There are many underlying dynamics that may be at work causing an undervalued or overvalued market.
  • Uneven Valuations – A market may be considered undervalued in the aggregate, but it’s certainly possible for a certain sector to be overvalued. The inverse may also be true, where an overvalued market may house undervalued segments. Investors should be aware of these dynamics when investing in specific sectors.
  • Chronic Valuations – A market may be chronically undervalued compared to other markets around the world for any number of reasons. For instance, certain emerging markets with high political risks may be substantially undervalued over long periods of time, which doesn’t necessarily mean they will ever reach a fair value.

The most important thing to remember for international investors is to use the ratio as a starting point for further research rather than an end-all-be-all. There are many different factors that go into identifying an investment opportunity and the country of origin is only a single factor. Investors should also consider the investment merits of the equities within the country—in terms of their valuation and growth prospects—as well as potentially non-country-related factors, such as commodity prices.

Key Takeaway Points

  • Warren Buffett is known for using the market cap to gross national product ratio when determining if equities are overvalued or undervalued in aggregate.
  • International investors can find the same data for all countries using tools provided by the World Bank and other international organizations.
  • When using the ratio, investors should be sure to use it only as a starting point for implementing various strategies, including long-short strategies.