Warren Buffett has revealed his preferred method for determining stock market valuations, using a ratio that divides the total market capitalization of U.S. stocks by gross national product (GNP) rather than gross domestic product. According to The Motley Fool, Buffett explains that 'The market value of all publicly traded securities as a percentage of the country's business — that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.' At the end of October, the total market capitalization of U.S. markets reached $22.9 trillion, with the S&P 500 rising 1.5% since then. Using third-quarter 2013 GDP data of $16.86 trillion and projecting GNP at $17.1 trillion, this calculation yields a 134% ratio that places the market in the 94th percentile of results over the past 60 years, well above the 60-year average of 78%.
Buffett has established specific warning levels for this market indicator, as reported by The Motley Fool. 'If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire.' The current 134% ratio significantly exceeds the 70-80% range that indicates favorable conditions for stock purchases. This valuation metric provides a practical framework for assessing market overvaluation beyond traditional price-to-earnings ratios, offering investors a clearer picture of overall market pricing relative to economic fundamentals.
Despite his preferred valuation method, Buffett continues to question the practical value of economists in stock market investing. According to reports from Live Mint, Buffett observed that 'Economists don't make a lot of money buying and selling stocks — but people who buy and sell stocks listen to them.' This statement highlights what Buffett views as an overreliance on macroeconomic predictions in a domain where they often add little value. Throughout his career, Buffett and his longtime partner Charlie Munger have largely ignored macroeconomic variables such as interest rates, GDP growth, or credit cycles when making investment decisions, focusing instead on understanding what a company is worth and comparing it to its current market price.
Several additional factors support the overvaluation assessment beyond Buffett's preferred indicator. As reported by The Motley Fool, corporate profit margins are at all-time highs while earnings are not growing, with the S&P 500 rising on earnings-multiple expansion rather than earnings growth. The cyclically adjusted P/E ratio (Shiller P/E) stands at 25, approximately 50% above its historical average of 16.5. Respected investors including Jeremy Grantham, Wally Weitz, Donald Yacktman, Steven Romick, and Seth Klarman are building large cash positions, indicating they do not see current market opportunities. The Federal Reserve's $85 billion monthly quantitative easing program and $4 trillion balance sheet continue to support market levels, though this monetary policy may extend the current overvaluation period.
