Wednesday, July 22, 2015

Buffett’s Ratio Is Bearish (excerpt)

Warren Buffett’s favorite valuation model is screaming that stocks are overvalued. It was discussed in a 7/20 Business Insider article titled “Warren Buffett’s ‘single best measure’ of stock market value falls short in 3 big ways.” The article was based on a note to clients on Monday from Bank of America Merrill Lynch’s Savita Subramanian. She wrote that Warren Buffett’s favorite metric of long-term value “may have limited utility.” The market-cap-to-GDP ratio, which he once characterized as the “single best measure” of value, is used to determine whether the stock market is overvalued or undervalued. Here are the three shortcomings of the Buffett ratio according to BAML and my thoughts:

(1) Like price-to-sales ratios, the Buffett ratio doesn’t adjust for structural changes in profit margins due to lower taxes, lower interest expense, and higher operating margins attributable to technological innovation.

Maybe so, but that assumes that these changes are indeed permanent. They may be, but that is quite debatable. The implication that the profit margin may remain structurally high is a radical idea given that it has been a highly cyclical variable since the beginning of recorded time, i.e., since 1947. There are lots of reversion-to-the-mean believers who would vociferously dissent from the view that margins may remain higher than in the past.

(2) On average, more than half of S&P 500 revenues come from overseas. So comparing the index’s market cap to domestic GDP is flawed. It would be more accurate to measure it relative to a global measure of GDP.

I calculate the Buffett ratio dividing total US equity market capitalization excluding foreign issues by nominal GDP. Interestingly, it is almost identical to the market cap of the S&P 500 divided by the index’s revenues, which includes both domestic and overseas revenues. Both are near their peaks during 2000, suggesting that stocks are indeed extremely overvalued.

(3) The market cap of the S&P 500 has a much different industry mix than GDP. So the ratio is comparing apples and oranges.

I don’t disagree. However, I long ago concluded that every valuation model has flaws. That’s why I try to track them all. I see are lots of valuation measures that look quite stretched to me. But then again, valuation, like beauty, is in the eye of the beholder.

Today's Morning Briefing: Challenges for Earnings. (1) The dollar and oil price could weigh on earnings again. (2) Industrial commodity prices may also be signaling trouble for earnings. (3) The Boom-Bust Barometer may be running out of boom. (4) Will rebound in forward earnings move forward? (5) Are Gordon-type models really bullish for valuation? (6) The Buffett ratio is bearish, and it is flawed according to top Wall Street strategist. (7) Most valuation models are flawed for one reason or another. (8) Valuation is subjective. (More for subscribers.)

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