Buffett and Barclays Market Indicators Send Warning to Stock Bulls
Warren Buffett
(Bloomberg) — The US stock market has roared past every caution sign on its way to a dizzying 36% surge since the April lows. It’s now staring down one favored by investing legend Warren Buffett.
The “Buffett Indicator,” an imperfect but useful metric for assessing whether equity valuations have become bloated, has risen past its pandemic-era record that preceded 2022’s bear market. The measure pits total market capitalization of US stocks, currently at around $72 trillion, against gross domestic product. These days, it shows the stock market is more than twice the size of the economy, even after GDP grew at the fastest pace in nearly two years.
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“The current ratio naturally suggests equities are overvalued and echoes concerns about bubble-like behavior,” Barclays derivatives strategists including Stefano Pascale said in a note to clients. Even though the indicator isn’t without limitations, it’s “still prudent for investors to consider the record stock market capitalization-to-GDP ratio as another warning sign of excessive euphoria.”
The Barclays team earlier this year introduced its own gauge to measure euphoria in the market using options data going back to 1997. Conceived as the AI revolution was minting billions in value for a handful of big tech firms and comparisons to the dot-com bubble of the late 1990s abounded, the idea was to help investors watch for stretched positioning and signs of irrational exuberance.
They found that their indicator tends to mimic moves in the Buffett Indicator, and now it’s flashing similar warnings. It measures the proportion of euphoric stocks within a universe of US equities that have liquid options, currently around 11%, compared with its long-term average of 7.1%. The gauge peaked above 10% during the dot-com era of the late 1990s and the meme-stock frenzy of 2021.
Concerns about market froth have persisted for months as price-to-earnings ratios in the S&P 500 have climbed to levels achieved only before past meltdowns. Bears have also warned that a cooling labor market and signs of stress among lower-end consumers mean the US economy is on shaky footing. Still, companies have continued to deliver solid earnings and artificial intelligence spending has boosted economic activity.
Buffett cautioned in 2001 that when the valuation-to-GDP ratio reaches the level it’s at now, investors are “playing with fire.” The Berkshire Hathaway Inc. honcho also warned against viewing the gauge in isolation, saying at the company’s 2017 shareholder meeting that “it’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.”
Buffett emphasized that while “every number has some degree of meaning,” its importance can vary greatly depending on the context.
The Buffett Indicator’s track record bears out the words of caution. In May, it signaled that equities were relatively cheap just as they were embarking on a historic six-month surge. Before that, the indicator flashed a warning signal in the spring of 2019, only for the S&P 500 to proceed to new highs.
The composition of the stock market has undergone a sea-change in the past two decades, with big tech firms that generate massive amounts of cash accounting for nearly one-third of the S&P 500’s market cap. Other issues with the indicator include US companies’ growing exposure to global earnings opportunities, while GDP is a measure of domestic activity, Pascale said. Plus, “equities investors tend to be optimistic when things go well,” which is reflected in expanded GDP, he added.
There are reasons to discount both measures, though, chief among them corporate profits. Earnings are ballooning, supporting higher share prices, with third-quarter results among the strongest in years. For the more than 70% of S&P 500 companies that have reported so far, profits have surged nearly 13% from a year ago, while sales are rising at their fastest pace in three years, according to Bloomberg Intelligence.
Year-over-year earnings growth for the median S&P 500 company was at the top of its typical range, and was near the highest in the last 15 years, excluding a boom during the recovery after the pandemic era, Deutsche Bank AG strategists wrote in a Nov. 4 note. Plus, earnings growth in US stocks “broadened across several dimensions,” allaying concern that it was concentrated in just a handful of big-tech companies.
The market narrative has recently shifted, with fresh questions about market concentration spurring anxiety about an equity correction, Deutsche Bank strategist Jim Reid wrote in a separate note. He called Tuesday’s near-8% drop for Palantir Technologies Inc. “emblematic of this shift, particularly given they’d actually raised their revenue outlook the previous day.” Still, Reid said that as the data analysis company’s stock had quadrupled in the last year, “that’s set the bar incredibly high for any earnings releases.”
While the market is entering a period of seasonal strength, there’s still room for caution, Barclays strategists said, advising investors that “renting upside remains a prudent strategy to lock in recent gains while limiting risk.”
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