The Buffett Indicator is one of the best indicators as to where the stock market should be at any given point in time. The indicator is stock market capitalization divided by gross domestic product (GDP). In the past, U.S. stock market capitalization was used in the numerator of the Buffett Indicator; today, world market capitalization is more frequently used.
If you’re not aware, “market cap” means the combined value of all shares in a company or index. At today’s S&P 500 index level, the Buffett Indicator is 184%. This level tends to indicate overvaluation but, as you’ll see, that needn’t mean a crash is coming.
What the Buffett Indicator tells us
The Warren Buffett Indicator is a good stock market indicator because it tells us, basically, what percentage of the economy’s money is being spent on stocks. When a very high percentage of the money supply is in stocks, then there is little free cash available to invest in it. That fact tends to curb stock market returns in times when stocks are high relative to GDP.
Also, if the stock market is trading at a high percentage of GDP, then stock prices are likely high compared to earnings and cash flows — all of these metrics are ultimately components of GDP. The higher that stock prices are as a percentage of GDP, the more likely it is that stocks are overvalued.
The modified Buffett Indicator
Ever since Warren Buffett popularized the Buffett Indicator in 2002, variations of it have been created. One version was proposed by the economist John Hussman. This version values the market in terms of non-financial market cap divided by gross value added. In plain English, this is the value of all companies that aren’t banks, insurers, or credit card companies over the contribution that traded company earnings make to GDP. It’s based on the same essential logic as the Buffett Indicator, but it’s a little more precise. It, too, currently is sitting at a high level.
Some stocks that are cheaper than average
Despite the stock market’s overall steep valuation, some individual equities are cheap. One category of stock that is cheaper than the average rate now is bank shares. Canada’s big banks generally trade around 10 times earnings, which is much cheaper than the S&P 500. If a good company can be bought for 10 times earnings, then it’s likely to also be a good stock.
Consider Toronto-Dominion Bank (TSX:TD), for example. It currently trades at 12 times earnings, which is around half of the S&P 500’s price-to-earnings ratio. Granted, TD’s growth isn’t as rapid as that of the big U.S. tech stocks that dominate the S&P 500. However, it’s surprisingly strong for a bank.
In the most recent quarter, TD’s GAAP (generally accepted accounting principles) earnings grew 79% year over year. That’s a very high growth rate. The adjusted earnings were held back by some losses on investments the bank made related to its failed acquisition of First Horizon. Those were one-time charges that won’t recur into the future. TD’s U.S. retail business continues growing, and its Canadian business is also doing well. All in all, TD Bank is a decently cheap and growing company.
