In 2001, Warren Buffett famously declared the ratio of total stock market capitalization to gross national product as the "the best single measure of where valuations stand at any given moment."
This all-important ratio is now signalling the S&P 500 is overvalued, but Richard Bernstein of RBA Associates, one of the few market strategists with a track record strong enough to legitimately question the Oracle of Omaha, says that times have changed, profits matter more than the U.S. economy, and that investors should remain bullish.
Two charts below illustrate why I side with Mr. Buffett's view, though with some important caveats.
The first chart shows why Mr. Buffett is concerned. The current market cap to nominal GNP ratio is over 104 per cent. This is well above the pre-crisis peak of 97 per cent, though not quite in the nosebleed territory of the late 1990s.
S&P 500 Market Cap/GNP vs S&P 500
SOURCE: Scott Barlow/Bloomberg
Richard Bernstein, former chief quantitative strategist at Merrill Lynch and founder of Richard Bernstein Associates, recently made his point bluntly during an interview with CNBC, saying "What is more important than [the U.S. economy] is corporate profits."
He clarified his view relative to the Buffett indicator on Twitter by noting that "[market value to GDP] chart making the rounds. Ignores structural change in corporate profits within economy. Should be MV/Corp Profits."
Mr. Bernstein's statement suggests the Buffett indicator is no longer relevant and the connection between the U.S. economy and the S&P 500 is no longer valid. In his defense, the current S&P 500 Market Cap divided by trailing 12-month profits is 17 times, well below the post-2000 average of 24.
The structural changes Mr. Bernstein refers to are the rising international share of total revenue for U.S. corporations, which make corporate profits less sensitive to the domestic economy, as well as the historically low interest rates that allow for share buybacks and debt re-financing. Businesses with ultra-high profit margins like Google Inc. – well above levels for old economy manufacturing stocks that used to dominate the benchmark – may also play a role in changing the relationship between the S&P 500 and the U.S. economy.
The data supporting "this time it's different " thinking about S&P 500 profits and the U.S. economy hits a snag in 2011, however. As the second chart illustrates, the ratio of S&P 500 profits and GNP rolled over at levels very close to the pre-crisis highs, causing considerable equity market volatility. It is difficult to believe that the underlying structure of the world's most important equity benchmark has changed significantly in the last three years. It appears that the relationship noted by Mr. Buffett between equity market performance and the U.S. economy remains intact.
TTM S&P 500 Market Cap/GNP vs S&P 500
SOURCE: Scott Barlow/Bloomberg
That said, a renewed surge in corporate profits despite weaker U.S. growth could confine Mr. Buffett's best single valuation measure to history's dustbin. But Mr. Buffett's valuation tool stands at levels suggesting danger and profits relative to the U.S. economy are at a place where they have rolled over twice in the past decade.
Follow Scott Barlow on Twitter at @SBarlow_ROB.