Over 20 years ago, Warren Buffett put forward an idea to measure the attractiveness of the US stock market. It became known as the Buffett Indicator and is a variation on the price-to-earnings (P/E) ratio that is commonly used by investors to assess individual stocks.
How it works
Applying the theory to this country, the idea is that by comparing the market cap of the London Stock Exchange with national income (gross domestic product), it’s possible to make an assessment as to whether UK shares are fairly valued.
Since 2013, the indicator has never been lower. This implies there’s a once-in-a-decade opportunity to buy apparently undervalued UK stocks.
| Year | Stock market valuation (£trn) | Nominal GDP (£trn) | Buffett Indicator (%) |
| 2013 | 4.258 | 1.782 | 239 |
| 2014 | 4.091 | 1.863 | 220 |
| 2015 | 3.958 | 1.921 | 206 |
| 2016 | 4.582 | 1.999 | 229 |
| 2017 | 4.235 | 2.085 | 203 |
| 2018 | 3.787 | 2.157 | 176 |
| 2019 | 3.925 | 2.238 | 175 |
| 2020 | 3.639 | 2.110 | 173 |
| 2021 | 3.995 | 2.270 | 176 |
| 2022 | 3.732 | 2.491 | 150 |
| 2023 (at 30 June) | 3.534 | 2.491 (2022 figure) | 142 |
Is it reliable?
Critics argue the theory is a bit too simplistic.
A country’s income only measures domestically generated sales. And most public companies derive the majority of their revenues from outside the countries in which they are listed.
But it has been known to predict stock market corrections.
At the end of 2007, it was 280% — roughly twice what it is now. The following year, the FTSE 100 recorded its worst annual fall, losing over 30% of its value.
To me, the UK stock market does appear undervalued. The FTSE 100 reached an all-time high in February 2023. But since then it’s fallen back, and is now 6% lower.
The index is dominated by energy companies, mining stocks, and banks. Commodity prices have declined on fears of a global economic slowdown. And earlier in the year, three of the four largest US bank failures in history led to the sector falling out of favour with investors.
In contrast, the US tech-heavy NASDAQ index has increased 38% since the start of 2023.
What should I do?
Warren Buffett advises investors to be greedy when others are fearful.
This sounds like good advice to me. If I was in a position to do so, I’d be investing now in quality UK stocks.
And just like I’ve been using the Buffett Indicator to assess the attractiveness of the market as a whole, I’ve looked at the P/E ratios of some of the stocks in the FTSE 100 to try and identify a few bargains.
Shell and BP have ratios of six. This compares favourably to that of Exxon Mobil, the world’s largest listed energy company, which is valued at 10 times’ earnings.
Banks also appear to offer good value at the moment. The P/E ratios of Barclays (4.7), Lloyds (5.7), and HSBC (6.8) are all comfortably below the FTSE 100 average of 10.
Housebuilders Barratt Developments, Taylor Wimpey, and Persimmon have ratios of 7–8. Two years ago they were all over 10.
For comparison, Tesla currently trades at 85 times’ earnings.
Of course profits can fluctuate wildly from one year to the next. And there are specific reasons why each of these companies — falling energy prices, increasing loan defaults, and a further loss of confidence in the housing market — might see further pressure on their stock prices.
Final thought
Hopefully, the Buffett Indicator is right and a UK stock market bull run is not too far away. But, in some respects, it doesn’t really matter.
I think there are many stocks of undervalued companies available at the moment. I’m confident that quality will always win through, regardless of what’s happening in the wider market.
