The Buffett Indicator: What It Is — and What It Is Not
This is a follow-on to my earlier piece, The Most Misunderstood Phrases in Buffett-Speak: Free Cash and the Float.
A quick distinction: GDP (Gross Domestic Product) measures economic activity within U.S. borders. GNP (Gross National Product) includes income American companies earn abroad. Buffett's original 2001 analysis used GNP; most modern versions of the indicator substitute GDP.
What the Buffett Indicator Is
The Buffett Indicator is a measure of stock market valuation. It compares the total value of the stock market to the size of the economy—specifically, total market capitalization divided by GDP. The result is expressed as a percentage.
Warren Buffett described this ratio in a 2001 Fortune article as “probably the best single measure of where valuations stand at any given moment.” He offered two reference points: if the ratio falls to the 70% or 80% range, the market is undervalued. If it approaches 200%, the market is overvalued.
How Warren Uses the Buffett Indicator
He doesn’t.
Buffett doesn’t use this indicator in his own investing, and he doesn’t recommend that the public use it when making investment decisions. There is no evidence in his letters, interviews, or investment behavior that it plays any role in capital allocation decisions. His general advice—buy a low-cost S&P 500 index fund, invest regularly—has no conditions tied to valuation levels.
It would seem logical to assume that you should not buy stocks when the market is overvalued, or that you should buy when it’s undervalued. Buffett has never suggested that people use this indicator to make that decision.
The indicator is like knowing that this winter will be warmer than usual. It doesn’t tell you what to wear each day.
How Warren Decides When to Buy Stocks
Buffett evaluates individual businesses, not the stock market. He looks at the fundamentals of a specific company—its cash generation, its competitive moat, and whether the price offers a margin of safety. He pays no attention to what the overall market is valued at.
As a side note: Berkshire Hathaway is currently sitting on a record amount of cash. This is not because the Buffett Indicator is telling him the market is overvalued. It’s because he can’t find anything to buy that meets his business valuation criteria. If he found a compelling opportunity tomorrow, he’d buy it—regardless of what the indicator says.
What Warren Recommends That Individuals Do
Buffett doesn’t recommend that individuals do what he does. Evaluating businesses the way he does is difficult, and most people don’t have the time, skill, or temperament for it.
Instead, his advice is simple: buy a low-cost S&P 500 index fund. Use dollar cost averaging—invest a fixed amount at regular intervals. If you have a lump sum, just put it in. Don’t worry about whether it’s the right time.
Notice what’s missing: any reference to market valuation. No waiting for the Buffett Indicator to drop. No timing the entry.
In neither his individual stock picking nor his advice for individuals is there any recommendation of how to time purchases relative to the Buffett Indicator or any other measure of current stock market valuation.
It would be very easy for him to say: purchase S&P 500 index funds when the market is not overvalued by my Buffett Indicator. He has never said nor implied that you do that.
It’s important to note that Warren, using his great ability, has not been able to beat his own simple formula for buying S&P 500 index funds for many years now.
In a future article, I’ll run some numbers to back up what he says here and explain some additional details about his exact advice.
What Is the S&P 500 Index?
The S&P 500 is an index of 500 large U.S. companies. It represents roughly 80% of total U.S. stock market capitalization. When you buy an S&P 500 index fund, you’re buying a slice of all 500 companies.
An S&P 500 index fund is what’s called an unmanaged fund. No one is deciding which stocks to buy or sell, or when. The fund simply tracks the index. A committee at S&P Dow Jones Indices decides which companies are added or removed, using eligibility criteria like market cap, liquidity, and profitability—but the committee exercises judgment, and changes are infrequent to maintain stability.
What About the Experts?
What about all the genius hedge fund managers and stock market predictors we listen to on cable news and in the newspaper—with all their micro advice, worrying about the Fed rate and the price of tea in China?
There is little evidence that any of this—sophisticated or otherwise—will help you beat the S&P 500. You are more likely to do much worse. Trying to time the market is a fool’s game and it has been shown as such when subjected to objective measurements and study.
In 2007, Buffett made a million-dollar bet that a simple S&P 500 index fund would outperform a selection of hedge funds over ten years. Ted Seides of Protégé Partners took the bet and picked five funds-of-funds, which invested in over 100 hedge funds—representing some of the best minds on Wall Street.
The result wasn’t close. By the end of 2017, the S&P 500 index fund had gained 125.8%. The five hedge funds gained 2.8%, 21.7%, 27.0%, 42.3%, and 87.7%. The proceeds went to Girls Inc. of Omaha.
Why Doesn’t the Buffett Indicator Tell You When to Buy?
A technical note: The modern "Buffett Indicator" typically uses the Wilshire 5000 and GDP. Buffett's original 2001 analysis used the total market value of all U.S. equities from Federal Reserve data, compared to GNP—Gross National Product, not GDP. The distinction matters less than what it reveals: people have taken a casual historical observation and turned it into a rigid rule using substituted data. Even the formula has drifted from what Buffett actually wrote.
The Buffett Indicator uses the Wilshire 5000 to approximate the total value of the U.S. stock market. The Wilshire 5000 is a rules-based index created in 1974, named for the roughly 5,000 stocks it then contained. Any company headquartered in the United States, traded on a major exchange, and with readily available price data is automatically included. There’s no minimum market cap. Today it holds around 3,400 stocks.
The Buffett Indicator may very well predict the returns of the Wilshire 5000 over long periods of time. Studies suggest it explains a large portion of ten-year return variation.
But Buffett doesn’t recommend that you buy the Wilshire 5000. He recommends that you buy an S&P 500 index fund—a different index of 500 large companies.
The Buffett Indicator is not an S&P 500 indicator. It is a Wilshire 5000 (as a general stock market approximation) indicator.
The Buffett Indicator measures one thing. His advice tells you to buy something else.
Summary
The Buffett Indicator is not used by Buffett for his own purchases, nor does he recommend that individuals use it to decide when to buy S&P 500 index funds.
It’s a curiosity for him is the best way I can describe it. If he looks at the broad market as measured by the Wilshire 5000, his formula is a good overall predictor of valuation. But he does not use any market indicators to decide when to buy stocks, nor does he recommend that the general public use them that way either.