How The Buffett Yardstick Shows Both ‘Sky-High’ Stock Market Valuations And Investor Sentiment

The following post was based on an excerpt from a recent report published in The Felder Report PRO

Warren Buffett recently said, “Prices are sky-high for businesses possessing decent long-term prospects”. And I wouldn’t be surprised if he was looking at the whole of Corporate America when he wrote it. According to his own measure, stocks are just as highly-valued today as they were near the peak of the dotcom mania. The chart below plots the total value of U.S. equities to the total size of the U.S. economy. In December of 2001, Mr. Buffett wrote of it, “it is probably the best single measure of where valuations stand at any given moment”.

(Click on image to enlarge)

What really makes this measure so valuable is that it is very good at telling you what your returns will likely be over the coming decade. As Mr. Buffett has famously said, “the price you pay determines your rate of return”. Pay a cheap price, like investors were able to do back in the early 1980s, and you will get a fabulous return. Conversely, if you pay a steep price, as investors did 20 years ago, you will get a very poor annualized return over the coming decade. Currently, this measure suggests equity investors will like to receive something in the neighborhood of negative 2% per year, including dividends, over the coming decade.

(Click on image to enlarge)

What should really jump out at you, however, when looking at the chart above is the dramatic difference between forecast returns (red line) and actual returns (blue line) over the past decade. To my way of thinking this is simply the difference between the amount of return justified by the fundamentals and the amount of excess return driven by investor euphoria. Notice the last time this happened was at the peak of the dotcom mania. The chart below plots the difference between actual and forecast returns alongside the Michigan Consumer Sentiment index. It’s pretty clear to see that excess returns can almost entirely be explained by optimistic sentiment (ht @NoBServations).

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Disclosure: Information in “The Felder Report” (TFR), including all the information on the Felder Report website, comes from independent sources believed reliable but accuracy is not ...

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