This Indicator Is the Closest Thing to a Crystal Ball for Stocks

by Anthony Summers, Senior Research Analyst, The Oxford Club


Predicting which way the market will move next is impossible. (In fact, Chief Income Strategist Marc Lichtenfeld said it here last Thursday.) But today’s chart comes strikingly close to doing just that...

It shows the “crystal ball” of indicators - one that has an uncanny knack of illustrating the market’s future.

Legendary investor Warren Buffett called it “the best single measure of where valuations stand at any given moment.”

Which is why many traders refer to it as the Buffett Indicator.

It’s the ratio of market capitalization to gross domestic product. It’s used to gauge how large the overall stock market is compared to the economy.

For today’s purpose, we’re using the Wilshire 500 Full Cap Price Index as a representation of the total U.S. stock market. When you divide it by GDP, you get the blue line in our chart above.

When stocks are overvalued relative to the economy (a ratio of greater than 1), we should expect smaller (or even negative) returns as we approach a market sell-off.

But when stocks are relatively undervalued (a ratio of less than 1), we should expect larger returns as the allure of cheap stocks draws investors back into the market.

To prove this point, we have a second metric outlined on the chart.

The green line represents the S&P’s compound growth rate during a rolling 12-year period. It sounds complicated, but it’s quite simple. For example, the growth rate from 1990 to 2002 is plotted at the beginning of that period, 1990, on the chart.

Since we can’t use data that doesn’t exist yet, the line stops 12 years ago. (After all, we can’t really see into the future here...)

As you can see, the secondary y-axis is inverted in our chart (returns go from negative to positive). This is to show just how staggering the correlation is between the Buffett Indicator and the 12-year return rate.

Aside from some obvious points of divergence, the broader movement of both metrics reinforces our thesis...

As valuations move up, long-term returns start to shrink. And as valuations drop, long-term returns rise.

So what is the data telling us about our current market?

While we can’t make a precise prediction of future returns, the Buffett Indicator does offer us a range of returns we should expect. And judging from what we’re seeing... it looks like we could be entering low-return territory for stocks.

That’s not exactly great news. But it certainly doesn’t warrant a full-blown panic. And it lends zero credence to the notion that a large-scale recession is close at hand.

The Buffett Indicator merely provides a broad outlook over the next decade. And as far as the near term goes...

As Marc Lichtenfeld recently pointed out, “While the market may be slightly overvalued by historical standards, it’s hardly in a bubble.”

Historically, stocks are still the best-performing asset class, bar none. The key here is to maintain realistic expectations and take every step necessary to hold on to what’s yours.

Chart of the Week