The Market Value of Equity-to-Gross Domestic Product Ratio as a Predictor of Long-term Equity Returns: Evidence from the U.S. Market, 1951-2019

Abstract

In a 2001 interview in Forbes, Warren Buffett suggested that the ratio of the market value of publicly traded stocks to economic output could identify potential equity market mispricings. This paper investigates the return-predictive characteristics of the market value of equity-to-gross domestic product (MVE/GDP). The empirical evidence shows that the so-called “Buffett ratio” possesses consistent and statistically significant predictive power over longer time horizons (c. 10 years) for the U.S. market between 1951 and 2019. Historically, low MVE/GDP ratios have produced above-average investment returns, while periods of high MVE/GDP ratios have, on average, been followed by disappointing returns over the subsequent 10-year period. Current valuations in the upper historical range would appear to suggest that the relative high returns since 2009 are unlikely to continue. While U.S. equities as an investment class should not be discarded altogether, return expectations should be aligned to the somewhat sobering empirical observations that comparative valuation levels have historically been followed by moderate returns in the lower one-digit percentage range and occasionally in negative territory.