Rochester, Kent – How do you value the stock market? Writing in Fortune, legendary US investor Warren Buffett has recently given his views on how to make a judgement.
For any particular country, Buffett simply gauges the total market value of all publicly traded equities as a percentage of the gross domestic product. While Buffett admits the ratio has "certain limitations", he adds that it is "probably the best single measure of where valuations stand at any given moment".
Using historical US data, Buffett states that when the percentage falls to around 70-80%, "buying stocks is likely to work very well for you". But if the ratio approaches 200%, Buffett cautions, "you are playing with fire". With the Dow Jones around 9,900, the US stock market is valued at 133% of US GDP. Hence Buffett's present expectation for the US stock market is a long-term return of 7% (assuming 2% inflation), a performance somewhat below historical standards.
But what about the UK stock market? This country's annual gross domestic product is around £975b at the moment, while our stock market had a collective value of £1,462m at the end of October. Buffett's ratio would thus come to 150%.
But as Buffett says, there are limitations with the calculation. For instance, the valuations of FTSE 100 heavyweights BP (LSE: BP.), GlaxoSmithKline (LSE: GSK) and Vodafone (LSE: VOD) are largely based on substantial overseas profits that aren't included in the UK's GDP figure.
While very interesting, Buffett's thoughts on the market should be of little interest to true investors. Contributors to an index tracker -- safe in the knowledge that the stock market typically beats all other investments over the long-term -- should continue to make their payments regardless of who says what about valuations. Meanwhile, stock pickers should concentrate on the valuations of individual companies, not the valuation of the overall market.
More: Buy While Stocks Last? | Buffett: Making Fortune Tellers Look Good
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