The “Buffett Indicator” and Emerging Markets

Market seers look at various indicators to predict future returns for stocks. By looking at the historical relationship between the indicator and the value of the stock market analysts seek to establish a statistical pattern that if repeated in the future can provide an indication of probable prospective returns for stocks from current levels. Several popular indicators used by forecasters include the following: market value to sales; market value to inflation-adjusted average ten-year earnings (CAPE); and market value to Gross National Product (GNP). This last one is known as the “Buffett Indicator” because Warren Buffett noted in 2001 that it is “probably the best single measure of where valuations stand at any given moment.” The underlying premise of the “Buffett Indicator” is that over the long-term corporate earnings remain constant in proportion to GDP. Though this is not true over the short term (e.g. corporate earnings have risen much more than GNP over the past decade), the assumption is that eventually they revert.

Let us look at the Buffett Indicator; first for the U.S. market, and then for several emerging markets. The chart below graphs both U.S. GDP and the U.S. stock market for the past sixty years. It is interesting to look at the graph in the context of Buffett’s investment career, which coincidentally extends for the sixty years of data. First, the period from 1960 to 1970 was one of consternation for value investors like Buffett who felt that valuations were extremely high. Buffett closed his initial partnership in 1969, partially because he felt valuations were too high to remain invested. Second, the period 1974 to 1997 which were Buffett’s most successful years. He thrived in the 1970s, an environment of very low valuations caused by high inflation. Third, 1998 to 2001 was a period of serious underperformance for Buffett, as he was out of the high-flying technology stocks. Fourth, from 2001 until today, Buffett has not performed as well as in the past, only outperforming the market during the large drawdowns of 2002 and 2008. The “Buffett Indicator” today points to very high valuations, and probably to a big opportunity for Buffett to capture alpha (relative market performance) in the next downturn.

It is easy to see why Buffett would like this indicator. When the market line is below the GNP line the investment environment is favorable to value investors like Buffett. When the market line is above the GNP line, the environment is favorable to “growth” investors who prefer leading-edge companies with rosy prospects.

In the case of emerging markets, we look at three countries: Brazil, Turkey and India (charts below). These three markets all have enough historical data to identify patterns, which is less true for markets with short histories like China and Russia. Brazil and Turkey are very volatile “trading” markets. India is a less volatile market with more extended trends. Our data is all dollarized because we are dollar-centric investors, but consequently both GNP data and market data are greatly accentuated by currency effects. The GNP data is from The World Bank.

Brazil

Following the “economic miracle” (1968-71), Brazil entered an extended period of rising inflation and malinvestment (1972-1980). During this period of high economic growth, the stock market greatly underperformed GNP, leading to exceptionally low valuations. During the period of “re-democratization”  (1982-1990), the market initially rallied strongly but then entered  into a long period of extreme volatility driven by various failed plans to bring economic stability. Since the economic stabilization brought by the Plano Real (1994) the stock market has followed GNP more closely, falling in periods of recession and rising during periods of economic growth and optimism. After the liquidity and credit driven boom of 2002-2010 economic recession and currency weakness has brought the market down. Since 2016 the market has rallied on the hope of new reforms and economic recovery. If this hope fades, the market is likely to resume its decline.

Turkey

Like Brazil, Turkey is a market of great stock market volatility cause by repeated economic instability and long periods of economic stagnation. Also, like Brazil, this volatility makes Turkey a great “trading” market. Though the market over time follows the course of GNP, over the shorter-term it constantly veers above and below the GNP trend line creating trading opportunities. Since the market collapse in 2008, the market has significantly disconnected from GNP. Unlike Brazil, where the market is pricing in economic recovery, the Turkish market is in deep value territory. Based on its history of sharp stock market recoveries, the current position well below the GNP trend line positions it for a sharp rally.

India

The Indian market has closely followed the GNP trend line. The chart below covers essentially the period since the economic “opening” launched by Finance Minister Manmohan Singh in 1991. This period, from 1991 to today, has been one of relative stability and rising economic growth, conditions which are highly favorable for stock market appreciation. Different to China or Brazil in the 1970s, the Indian market is dominated by profit-oriented private companies. The contrast with Turkey and Brazil is also obvious: the Indian market is much less volatile and has followed the course of a rising GNP more closely. Periods of relative pessimism, when the market has traded below the GNP trend line, have been valuable buying opportunities for the long-term investor, while the dramatic overshooting in 2008, in retrospect, was an obvious time to reduce positions. The market offered its last good buying opportunity in 2017 and today looks only slightly undervalued relative to the GNP trendline.

Problems with the Buffett Indicator

There are potential issues with the Buffett Indicator.

First, the underlying assumption of stable corporate earnings relative to economic activity may be wrong. Or it may be correct for the United States but not for other markets.

Second, there are many measurement issues. These relate to the accuracy of GNP measurements and accounting issues. Both GNP calculation methodology and accounting standards evolve over time, and this may undermine historical comparisons.

Macro Watch:

India Watch:

  • India’s strong economy leads global growth (IMF)
  • (King coal rules India (Economist)
  • Apple is struggling in India (Bloomberg)

China Watch:

China Technology Watch

  • China’s rise in bio-tech (WSJ)
  • Berlin blocks Chinese acquisition (Caixing)
  • The man behind Pinduoduo (WIC)
  • Wake up call for China’s chip industry (Caixing)

EM Investor Watch

  • Brazil’s populist temptation (Project Syndicate)
  • Turkey’s rejection of the West (FT)
  • Thailand’s economic challenge (Cogitasia)
  • GMO makes the case for EM

Tech Watch

  • The future of batteries (Wired)
  • The world’s largest solar farm in Egypt (LA Times)

Investing

  • Li Lu’s lecture at Beijing University (Himalaya Capital)
  • Charlie Munger and Li Lu Interview (Guru Focus)
  • Interview with Bill Nygren (Youtube)
  • The 8 best predictors of market returns (WSJ)

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