• Henry Mason

Whilst we mentioned Buffett

Updated: Feb 7

In the last post, we looked briefly at a Warren Buffett speech gave in the summer of 1999 in the run up to the bursting of the Dot Com bubble. He began by explaining some of his thoughts on the long term drivers of the stock market - namely corporate profits and interest rates.

The reason we posted about this is that there are comparisons being made between that Dot Com bubble and the stock market of today, partly also built around the rhetoric on the emerging divergence between Wall Street and Main Street. In this post, we are going to look briefly at some similarities and differences between these two periods, in order to shed some light on general stock market valuations at this moment in time.

Now, one of the main similarities (as referenced in the title) is that the "Buffett Indicator" is either at, or near, all time highs for these periods.

Before explaining the numbers behind this ratio, it is best to briefly describe its reasoning. As mentioned above, Buffett described the long term drivers of a stock's value as (1) the profits which can be attributed to that stock over its lifetime and (2) the rate at which you discount said profits. Taken in aggregate across the economy, this can be seen as corporate profits and the yield on government debt (as the underlying driver of the discount factor). Since corporate profits are a relatively stable percent of GDP, this means that the fundamental driver of changes will be GDP. Therefore, ignoring interest rates for the moment - and we will come back to this - the main long term driver of overall market capitalisation is GDP growth.

The Buffett Indicator looks at exactly this, and as such is quite simply total stock market capitalisation divided by quarterly GDP. There are some differences across sources over which measure of GDP is used, but quarterly GDP is used here as it seems to be the salient measure. Since the argument is that aggregate stock market value is determined by GDP, the relationship between the two should be constant, or to put it another way, their ratio should be relatively constant. There are many sources for the data, but to make my own indicator, I used the market capitalisation of the Wilshire 5000 and then quarterly GDP data from the Federal Reserve Bank of St Louis. This gives the below:

According to this (and now returning to the question of Dot Com-era-likeness), you can see why some are suggesting that the markets are as overvalued today as they where in the late 1990s.

However, as previously mentioned, this is based off corporate profits and GDP, and ignores the interest rate part of the equation, as well as quantitative easing. To add this in, I have added the inverted Z-score yield on 10 year Treasuries, as well as the size in billions of the Fed's balance sheet. This "inverted standardised yield" is literally the yield of the period's deviation from the long-run average yield, timed by -1. I used this for two reasons: first, it helps it all fit on my graph. Second, I inverted it to make the movements more intuitive: the "higher" the inverted yield (which obviously means lower yield), the more highly the return on equities is valued - hence the inverted yield and stock market value should be positively correlated.

Please note, data from the FRED on the size of the Fed's balance sheet was only found back to late 2002.

Whilst it is true that correlation does not imply an underlying relationship, this graph might add some colour to the story of why equity valuations are higher at this moment in time, compared to the Dot Com era. Namely, massive central bank intervention, forcing investors out to more risky assets (to the benefit of equity prices), via the relative poor return on government debt making the return of riskier assets look more attractive.

An excellent article was written on this theme by Martin Wolf of the Financial Times, and it is one we recommend all readers to have a look at - it makes for interesting reading, and proposes the argument, as per the article's title, that "There is no stock market bubble". This references the risk premium of equities versus bonds as the metric for judgement of whether equities are over/under valued. He says given today's low yield environment, equities prices are roughly in line with long-run averages. So, he says that instead of looking at this, "the big questions are whether real interest rates will jump, and how soon."

This is probably the main question - at what points will real rates rise? The interesting thing is that the bursting of the Dot Com bubble can be partly attributed to Alan Greenspan's signal to aggressively increase interest rates (following cutting them over Year 2000 concerns). So given that the Federal Reserve has signalled expectations of keeping rates where they are until 2023, one would have to think that this pressure does not exist as it did in 2000. However, it is worth mentioning that this does not mean capital markets in general will be fine - the Fed have signalled that they are willing to let inflation run above the 2% target for a "sustained" period of time, which could be problematic for fixed income markets. Whether that might then feed into equity markets is a question for another day.

Another divergence between the two periods, is that it seems valuations are more in check than they were in the late 1990s. Looking at the average PE ratios across the two time periods, you can see a clear difference: in early 2000, PE ratios maxed out at 175 for the Nasdaq, and 29 for the S&P 500, with the Nasdaq currently sitting near 39, and the S&P 500 at just below 38. This makes for interesting analysis - you could justify the high PE ratios being due to this years disruptions hurting profits against expectations for vaccine-driven profit rebounds net year. Without properly breaking all this down, it would be futile to try and draw out a conclusion beyond the obvious statement that both markets are expensive, albeit with the Nasdaq not being as near the same lofty valuations seen in 2000, and vice versa for the S&P 500. Another topic for another post is the IPO activity during the year - which equally deserves attention, given the activity at high valuations mirroring (to a less extreme extent) the late 1990s.

Interestingly, upon reading a few different sources, it seems that a point of comparison is an increase of retail investor participation, particularly towards the end of the bubble. The similarities do not end here: in both instances these retail investor inflows where coinciding with institutional investor outflows, and these institutional outflows were in both cases following on from insider selling (the most recent instance of which has been covered by a previous post). The increased participation of retail investors has been very well covered from the onset of the pandemic, and so perhaps the institutional outflows comparison is less well covered.

One good way of looking at this is the "Smart Money Index" or SMI. This takes the direction of the first half hour and last half hour of a day's trading activity to create a different index. This is based off the theory that institutional (and more complex - hence "smart") investors enact trades during this time, where other investors make trades throughout the day. Therefore, by creating an index only based off these two time periods of the day, you can see what the smart money is doing. As mentioned previously, in the run-up to the bursting of the Dot Com bubble, smart money was moving out as retail investors continued to pile in. This is mirrored in the present day: according to Market Watch, the SMI has moved consistently lower from September to date, where the S&P 500 has gone on to hit all time highs. This, combined with insider selling, would suggest that smart money investors are not as confident as other participants on future market performance. This draws an interesting parallel between the two time periods.

Ultimately, it seems that this bull market, whilst it does have similarities to the Dot Com bubble, does diverge on some major factors that makes this market seem less extreme. However, whilst it seems less extreme, this does not necessarily green light piling in. On one side, the smart is moving out which does raise concerns, but on the other side, to bet against the market is akin to opposing the Federal Reserve. It seems prudent advice for the average retail investor to not be too heavily weighted on either case being true.

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