As the stock markets have risen in recent years, I have been thinking about what Warren Buffett is doing it today’s market. His company, Berkshire Hathaway is currently holding $128 billion in cash. This also made me think of taking a look at the Buffett Indicator.
One of Warren Buffett’s favorite measures to observe is the price of the American stock market relative to the American Gross Domestic Product. GDP is defined as the total market value of goods and services produced within the borders of a country.
One thing to note is that over history there is a close relationship between economic output and stock market valuations. When there are large discrepancies, bad things tend to happen.
Wealth Versus Claims on Wealth
To understand why GDP should be closely correlated to the stock market, we need to think about what financial assets are. Warren Buffett has a net worth of around $87 billion dollars. His net worth represents claims that society owes him. He owns many financial assets:
- Cash that can be redeemed for goods and services
- Savings that are a claim against a bank’s assets
- Stocks which represent a claim on business assets and future earnings
- Bonds that are a promise to receive dollars in the future
Note that these financial assets are not wealth themself but rather are claims against society.
To understand this better, let’s review a thought experiment. What would happen if Warren Buffett was alone on a shipwrecked island? Think of something along the lines of Gilligan’s Island.
If he had a suitcase full of hundred dollar bills, would it matter? Would all of his wealth help him in his situation? Not at all, except to the extent that he could burn the bills to create heat.
Wealth is essentially the productive capacity of society. Our labor force and the skills they have built, the factory and productive investments that have been made, and the infrastructure and systems that provide services. Anything that helps create goods and services to the economy represents wealth.
For someone on a shipwrecked island, there is no production capacity to make goods and services and thus there is no wealth. The only wealth in your life is limited to what can be produced by your bare hands. Perhaps you can build a primitive structure to live in. Maybe you can catch fish to survive.
Another way to think of this is to think of a Baker who sells their goods for cash and then uses that cash to buy food. The currency is just a medium of exchange. The baker is not producing goods to earn pieces of paper. The baker is working in order to have the purchasing power to acquire get goods and services from others.
Wealth Versus Claims on Wealth
The reason tracking the stock market against the GDP is so powerful is because you are looking at the claims on wealth versus actual wealth itself. The GDP is an indication of how many goods and services the economy is able to produce. If the financial markets have too many claims against society, then those claims cannot be made good.
Where the markets stand coming into 2020 is at an extremely high valuation. The future claims on wealth is valued extremely high relative to the economy’s ability to create that wealth.
For investors, this will be resolved in either one of three ways:
- The economy will need to expand tremendously. If the GDP goes up substantially, then the stock market levels would be justified. Growth has historically been slow.
- The stock market will need to be stagnant for a long time until the GDP can “catch up” to the current level. This could mean a “lost decade” whereby stocks move sideways.
- The stock market will need to fall substantially to a level that makes sense relative to the GDP.
The first to me seems unlikely. The second and third are much more probable.
Looking from a historical context, the market is almost the most overvalued it has ever been. It is comparable to 1929 when the stock market panic that leads to the Great Depression kicked off. The only time that was valued higher was the dotcom bubble of 1999, and of course, that did not end well for investors.
Unfortunately, the stock market of the 2020’s era is likely to be underwhelming for investors. Most models are projecting low or negative returns going into 2028.
From an investor’s perspective, it would be wise to make defensive moves. This would include owning stocks that are less likely to collapse in a downturn, investing in real assets, and reducing holdings of risk assets in favor of safer assets such as bonds.
In my opinion, the fact that Warren Buffett is holding so much cash tells you a lot of his opinion of the market. If he thought the market was undervalued he would be deploying that cash rapidly and buying up assets.
Wealth is ultimately not the financial assets we hold but rather society’s ability to produce goods and services.