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How Buffett Values The Stock Market

Warren Buffett To some, Warren Buffett could possibly be the best investor the world has seen so far. While I’m sure others would have their own ideal candidates for the title of ‘Best Investor’, Buffett does make a strong case for himself. Through astute investing in the stock market and acquisitions of whole companies, Buffett has grown the per-share book value of his company Berkshire Hathaway by a total of 586,000% from 1964 to 2012.

On July 2001, Buffett gave a speech on the stock market to an audience of business leaders that was later converted into an article published on 10 December 2001 in Fortune magazine bearing the title Warren Buffett on the Stock Market.

The article mentioned a valuation measure used by Buffett where he looked at the total market value (TMV) of all publicly traded securities in the United States as a percentage of the country’s Gross National Product (GNP). It aims to measure the value that market participants place on the economic output of all the businesses with a country.

To Buffett, ‘TMV vs. GNP’ is “probably the best single measure of where valuations stand at any given moment” even though “ the ratio has certain limitations in telling you what you need to know.”

Because of his impressive track record, it’s generally a smart idea to take seriously his views on investing. So, how does a similar valuation measure, ‘TMV vs. GDP’ (where Gross Domestic Product is used instead of GNP) fare when applied to our stock market in Singapore? Let’s look at the chart below to find out.

How buffett values stocks

Source: Author’s calculations based on data from World Bank, SGX and Department of Statistics Singapore

In the chart, ‘TMV vs. GDP’ was plotted against the movement of the Straits Times Index (SGX: ^STI). And what we see, in the broadest sense possible, is that when the market pays too high a price for economic output, i.e. when the ratio of TMV to GDP breaches the 200% mark, the results afterwards are not pretty.

That makes absolute sense. Valuations matter for individual companies and there’s no reason why it shouldn’t apply to the broader market as well. Paying prices that are too high in relation to underlying fundamentals will always be a cornerstone of investing.

In any case, a more pressing question should arise when looking at the chart. Is the stock market over-heated? There are worries that stocks are due for even further pullbacks due to a slowdown in the US Federal Reserve’s stimulus efforts, despite the STI’s 9.7% decline from its 52-week high of 3,465 set on 22 May 2013 to its current level of 3,129.

Historically, it seems to be a good time to buy stocks when TMV is around 100% of GDP. The last point on the graph (which is based on latest available GDP figures as well as stock market capitalisation figures), puts TMV at around 150% of GDP so we’re definitely not in ‘good time’ territory. Bear in mind however, that the current ratio of TMV-to-GDP is also aligned with the historical average of 156%. So, on that measure, the market is probably in the Goldilocks-range – not too hot and not too cold.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Berkshire Hathaway.