INVESTING EXPLAINED: What you need to know about The Buffett Indicator

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s The Buffett Indicator.

What is this?

A ratio that aims to show whether a stock market represents good value.

It was devised in 2001 by American stock-picking guru Warren Buffett, manager of the Berkshire Hathaway fund, after the bursting of the dot.com bubble.

He describes the ratio as ‘probably the best single measure of where valuations stand at any given moment’.

The pronouncements of Buffett, 92, who is known as the Sage of Omaha, are becoming even more influential, if that’s possible.

His huge fan base now includes younger investors disenchanted with crypto currencies and high-risk ‘meme’ stocks who are looking for firms with long-term potential.

How is it calculated?

The total market capitalisation of all the stocks quoted on market is divided by the nation’s gross domestic product (GDP).

This yields a decimal-format value that is usually expressed as a percentage. In 1999, as the dot.com boom gathered strength, the US ratio was close to 200 per cent, which Buffett regards as dangerous territory.

In 2001, he wrote: ‘If the percentage falls to the 70 per cent or 80 per cent area, buying stocks is likely to work very well.’ The current reading for US stocks, based on the broadly-based Wilshire 5000 index of 3,600 stocks, is 181 per cent, suggesting a level of overvaluation, although traders seem largely unconcerned.

The reading for the UK, based on the FTSE 100, is 151 per cent.

Is the ratio a good guide?

Views differ. In 2007, before the financial crisis, the reading was nearing 200, sending out the signal that trouble was looming.

But critics question the ratio’s reliability, arguing that it does not reflect certain variables. For example, in an era of low interest rates, shares tend to offer better returns, meaning that it makes sense to put money into stock markets.

There is also said to be a mismatch between GDP and stock market valuations. GDP is a measure of one nation’s output, whereas firms in the FTSE 100 and Wilshire 5000 have international operations.

Companies in the FTSE 100 derive about 75pc of their earnings from overseas. You may, of course, conclude that these objections are minor and that no ratio can ever be an infallible guide.

Don’t we have the p/e ratio?

The price-earning (p/e) ratio is the better known indicator of whether a share or a stock market index represents value or not.The p/e ratio of the FTSE 100 is currently 10.64, against 21.77 for the US S&P 500.

You may think that the Buffett indicator is an added complication. But maybe with ratios, the more the merrier?

Why are we hearing about it now?

There is talk that its current level suggests that buying Britain makes sense.

Despite a strong start, the UK market has not flourished this year. The FTSE 100 is up just 1.86 per cent, against 20 per cent for the S&P 500 and 19.55 per cent for the Wilshire.

These increases have been powered by demand for stocks that could benefit from the adoption of generative AI (artificial intelligence). We will not know if Buffett is buying British until the publication of the list of Berkshire Hathaway holdings at the end of the second quarter.

For the moment, its only holding is a tiny stake in drinks giant Diageo.