In interviews with Fortune in 1999 and 2001, Buffett said that determining whether the market is expensive or cheap doesn't have to be complicated at all. His metric:
The market value of all publicly traded securities as a percentage of the country's business -- that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.
Basically, Buffett divides the total market capitalization of the U.S. stock market by gross national product, or GNP. Not to be confused with gross domestic product, GNP measures the value of goods and services that a country's citizens produced regardless of where they live -- including what American companies produce abroad.
So when does the metric tell whether the stock market is expensive? Buffett again:
If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire.
Where is the stock market trading today?At the end of February, the total market capitalization of U.S. markets, as reported monthly by the World Federation of Exchanges, was $24.6 trillion. The S&P 500 has risen 0.5% since then.
The Federal Reserve Bank of St. Louis, meanwhile, includes most U.S. economic data, though we won't get a report on GNP until the second revision of GDP on March 27. The most recent GDP data we have, for Q4 2013, is $17,080 billion. GNP has averaged $250 billion more than GDP for the past four quarters, so we shall assume Q4 2013 GNP is $17,107 billion.
Dividing the total market capitalization by GNP gives us a percentage of 142%, which, according to Buffett, indicates that the market is overvalued.
