TSX Buffett Indicator — Valuing the Market — Investing Ideas
Investing Ideas has always been about finding value investments. That’s easy when the market is low and stocks are cheap, but what about right now when stocks have risen for the past year and are reaching all time heights. The question becomes: is the stock market overvalued?
This is a question which a lot of value investors shy away from. I think that is unfortunate. Warren Buffet for instance, one of the all time greats, advises against timing the market, as does Benjamin Graham. And yet, when you boil it all down to the basics, Graham and Buffett have both tried, and succeeded, at timing the market throughout their careers. They just go about it differently.
Buffett Indicator
Buffett even has an indicator named after him called the “Buffett Indicator” which assesses the value of the US stock market. The indicator is super simple:
Multiply by 100 if you want percentage instead of a floating point number.
If you’re not good at math that’s fine. The takeaway is: the Buffett Indicator compares the stock market to the economy. The rationale is simple. It is a way to measure the fundamental value of the entire stock market.
It is simple logic really. Stocks represent companies. Companies operate in the economy. Thus, if the stock market is growing a lot faster than the economy, people must be overpaying. Simple right?
Unfortunately, it is hard to get a total value of the Canadian stock market. Therefore it is hard to get a reliable Canadian Buffett Indicator. I am aware that the World Bank publishes a Canadian Buffett Indicator of sorts, and I do recommend that you take a look at that. Unfortunately it is too delayed for many purposes (two years delay currently). This limits its usefulness.
The Solution
I had to MacGyver this problem. Here is what I came up with for the TSX and the Canadian GDP:
Calculated based on TSX/S&P Composite Index compared to Quarterly GDP by expenditure method. For the careful reader, be assured that this chart does show Q4. Excel just has an inexplicable reluctance to show the last date in the axis!
By dividing the TSX/S&P composite index by the nominal GDP for each quarter, this indicator achieves a similar purpose to the Buffett Indicator. That is why I call it the “Pseudo Buffett Indicator” (PBI) ™ . We can determine if the PBI is abnormally high or low by using standard deviations. The PBI should trade within 1 standard deviation 67% of the time and two standard deviations 98% of the time. Also remember that stocks are more expensive compared to the underlying economy when PBI is high.
This chart shows that by the end of 2020 the PBI was just under 1 standard deviation above the ‘85–2020 mean..
Current State of this Indicator
Since we are now at the end of Q1–2021, you might be thinking: what about Q1–2021? That’s where we run into a bit of a problem. Statistics Canada hasn’t yet published the results for Q1–2021. So an estimation of Q1–2021 GDP is necessary. If we estimate annualized GDP growth of 5% for Q1–2021, then the PBI would currently sit close to 1.3 standard deviations from the mean.
What does this tell us?
This PBI is probably reaching a “warning” threshold. What this chart communicates to me is that a market correction is likely imminent, not a crash.
Below we can see the PBI compared to the S&P/TSX Composite Index. What I want you to take a look at is the tremendous predictive power of this index for predicting crashes. As you can see, the PBI breached the +2 standard deviations threshold before both the dot-com bubble crash (2000) and the financial crisis crash (2008).
This chart demonstrates that, for the past five years or so, the Canadian stock market growth has been fairly “healthy”. “Healthy”, meaning that stock price growth has depended on actual growth in the economy. However, if the predicted value is correct then we are breaching a PBI level not seen since around 2010–2011, after which the market fell by about 2000 points (~15%) in the matter of approximately a year and a half.
In other words, the Pseudo Buffett Indicator is telling us that the Canadian market is not absurdly overpriced at the moment, despite first appearances. Yet, it’s definitely not time to throw all of your money into the TSX.
Conclusion
Of course, it is absurd to rely on just one feeble indicator to make your investing decisions. There are many factors which come into play. That being said, hopefully you feel you have a better grasp on the value of the TSX than before you read this article. I am searching far and wide for other indicators of TSX value. It is too bad that these are so much harder to find up here in Canada than down in the states. When I find them I will write about them. Until then,
Happy Investing.
Ps. A lot of this article is inspired by and informed by a really great article on the original Buffett Indicator. I highly recommend that you check it out because it goes in depth on the topic. Remember that the USA and Canada are very tightly interconnected, and that the state of the US Buffett Indicator could have major implications on the future of both markets.
Originally published at https://www.investingideas.ca on April 3, 2021.
