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Warren Buffett uses this as his market valuation tool. Here’s where it may screw you up if you use it

Barry Ritholtz explains in yesterday’s Bloomberg column an often mentioned Buffett’s indicator of general market valuation the Market Cap as a percentage of nominal GDP.

If measured quantitatively it does look since the 90s its been elevated. Basing on that as a sell signal you would have missed out much wealth building.

This is the same as Shiller’s CAPE, which is deemed a better PE since it uses 10 year average earnings. Since the 90s, its been consistently above 20 times.

Basing on these, we should be net sellers.

The guy that provides the data gives an insightful opinion:

Ron Griess, who runs the Chart Store, has been looking at charts for more than 40 years. He makes the observation: “There are no bad indicators. There ARE bad interpretations of indicators. I place the Market Cap/GDP indicator in the class of indicators that is often interpreted poorly.”

Why is that?

Knowing if something has a higher or lower value compared to its historic mean doesn’t provide much insight as to whether you should buy or sell it. Indeed, stocks can become, and stay, oversold or overbought for long periods of time. As some bulls will tell you, a persistently overbought stock is a sign of strength.

So what does market cap as a percentage of GDP tell us? The answer is: Much less than it used to.

Valuation relative to U.S. GDP assumes that the U.S. economy is the driver of capitalization. It really isn’t. Numerous studies have found very little correlation between current economic activity and the stock market.

Hope this helps.

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