What Buffett’s favourite ratio says about the Aussie market

Is the Aussie market overvalued or undervalued? Here's the 'best single measure' of market valuation and what it means for investors.

In 2001, Warren Buffett said in a Fortune Magazine interview that the stock market’s total market cap as a proportion of gross national product (see note) ‘is probably the best single measure of where valuations stand at any given moment.’

So how does the Australian market fare? If you take a look at Chart 1, a few things stand out. In 1987 and 2007 there are two large spikes in the ratio, which, as you might have guessed, coincide with the Black Monday crash and Global Financial Crisis. 

The other thing that stands out – for me at least – is the relative stability of the ratio since late 2009, which has bounced around between 80% and 100%.

These days, we can’t read the financial news without being carpet bombed with the words ‘bubble’ and ‘crash’. Yet, at least as far as Buffett’s favourite valuation measure is concerned, the ASX as a whole doesn’t seem particularly overvalued. In fact, where it stands today at around 92% is bang on the average of the last 15 years.

If anything, it’s surprising that the ratio isn't spectacular because interest rates very much are – they’re the lowest they’ve been since the 1960’s.

None of this is to say that you should rush out to buy or sell stocks. Buffett would be the first to tell you that market timing is a fool’s game. The market cap-to-GDP ratio is useless when it comes to predicting what’s going to happen next.

Ignore the market

So what’s an investor to do? Ultimately, you should forget about trying to value the market. Your job as a value investor is to find individual stocks that adequately compensate you for their specific risks. Even when the ratio was at its 2007 peak, there were still bargains to be had, just as there were plenty of overvalued stocks when it was at its low.

We first recommended members buy ARB Corporation back in 2004 and had an on-again/off-again buy recommendation all the way through the GFC. Even if you were unlucky enough to buy the stock at its 2007 peak – and endured the 40% decline during the GFC – you would still have almost tripled your money by the time we recommended you sell in 2013. Focusing on the market cap-to-GDP ratio would’ve meant missing out on buying one of Australia’s best businesses at a bargain price.

It’s natural that we want to stay up-to-date with what’s happening in the market, but ‘magic ratios’ like the one above play on our innate information bias – our tendency to believe that the more information we acquire, the better our decision will be, even if the additional information is irrelevant. This leads to overconfidence and risky behaviour. It steers you towards a short-term mindset and promotes active trading, which clocks up fees that eat into your return.

Investing is a long game. We can’t time markets, but we do know that cash is a lousy investment over the long term and you’re better off holding productive assets (see How much cash should you hold?).

If you’re investing for the next 10 or 20 years, whether the market cap-to-GDP ratio is 80% or 100% today probably doesn’t matter that much. What does matter is what the current share prices of your holdings are relative to each company’s intrinsic value. That’s it. If you stick to buying high-quality companies when they’re undervalued, you’ll do well no matter where the market stands.   

Note: We've used gross domestic product (GDP) because it was easier to access data. Both GDP and GNP tend to move in lockstep so it has no material effect on the ratio's volatility.

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