Warren Buffett’s favorite stock-market ratio is a more telling indicator of the outlook for share prices than one developed by Yale University’s Robert Shiller, according to a newly revised study.
The CHART OF THE DAY shows the market value of U.S. companies as a percentage of gross national product before inflation, using data compiled by the Federal Reserve and the Commerce Department. In a 2001 article for Fortune magazine, Buffett wrote that the ratio was “the best single measure of where valuations stand.”
A similar indicator, based on non-financial companies and gross domestic product, was cited in the study. The barometer was compared with Shiller’s cyclically adjusted price-earnings ratio, or CAPE, calculated by dividing the Standard & Poor’s 500 Index by average annual profit for the previous 10 years.
Shiller’s method is flawed because corporate events can affect a specific company’s earnings and the broader profit outlook differently, Stephen E. Jones, president of String Advisors Inc., wrote in his report.
CAPE’s ability to predict stock performance appears to be tied to “the tendency of longer periods of historical earnings to track GDP,” the New York-based money manager wrote.
The market value-GDP ratio works even better to forecast stock returns after adjustments for demographics and household income and spending, according to the study. The latest version was posted July 8 on the Social Science Research Network, an online repository.