The Dow Jones Industrial Average, Nasdaq Composite Index, S&P 500 Index and the Russell 2000 Index are at record or near-record highs. Fast-growing startups are running as fast as they can to IPO. Mergers and acquisitions are on the rise. Anyone caught up in these trends could easily assume that the worst economic times are behind us and that “champagne wishes and caviar dreams” are all that lie ahead. But some people—like the third richest man in the world, Warren Buffet—know better.
Buffett's Market Formula
For decades, Buffett has been able to consistently outperform other professional investors through a combination of rational analysis, encyclopedic financial knowledge and common sense. Unlike many hedge fund managers, Buffet isn’t secretive about how he makes such incredible investment returns. He’s actually very open about it through his interviews and annual shareholder letters. In 2001, he wrote a column with Carol Loomis where he shared with readers what he considers to be the most valuable signal for future stock market performance.
The signal that Buffett uses is a ratio between the Market Value of publicly traded companies to Gross Domestic Product (MV/GDP). According to this signal, when the ratio is high, meaning that stock prices are high relative to the value of goods and services produced, the risk of stock prices falling increases. When the ratio is low, the probability of stock prices increasing is higher.
There are different ways to measure MV and GDP, and, depending on which definition you use for each variable, the result will vary somewhat; what doesn’t change is the conclusion. Using a standard measure for MV from the Federal Reserve and GDP from the Bureau of Economic Analysis, the results are sobering:
Market Value = $21.222 trillion
GDP = $17.295 trillion
MV/GDP = 1.227
What the Numbers Mean
The MV/GDP could be signaling tough times ahead for the stock market. Its current value is higher (which means worse) than what it was right before the 2008 financial crisis, which led to massive stock market losses. At the end of September 2007, the MV/GDP ratio equaled 1.121.
For small-business owners, this indicator is valuable for several reasons:
- If you are invested in the stock market and are counting on using that money in the near term, it’s a good idea to re-evaluate the riskiness of your investments.
- If you are planning on borrowing money or raising capital from investors, they may lose their ability to write you a check if their stock market investors tank.
- If you are thinking of selling your business and accepting stock as the currency, a sharp drop in equity prices could significantly affect the value of your transaction.
A recently published study by Stephen Jones, president of String Advisors, confirms MV/GDP as a powerful-but-overlooked indicator of equity returns. As you can see, it isn’t that difficult to track even for novice investors, and it's something small-business owners need to keep their eyes on.
Read more articles about small-business finance.
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