May 12, 2022 2 min read

The Buffett Ratio Remains High

The Buffett Ratio Remains High

The Buffett Ratio rose to new record highs at the end of last year. In the past, Warren Buffett has opined that the stock market was overvalued when the ratio of the market capitalization of US equites to nominal GDP rose to around 2.0 or higher.

That's where it was just before the pandemic in early 2020. By Q4-2021, it rose to a new record high of 2.8. Another version of the Buffett Ratio can be derived by dividing the S&P 500 market capitalization by S&P 500 revenues. It rose to 2.7 at the end of last year. Both series track one another closely, but they are available only quarterly.

We can monitor the Buffett Ratio on a daily basis using the S&P 500's forward price-to-sales (P/S) ratio. It has plunged from 2.8 at the start of the year to 2.2 yesterday. Similarly, the forward P/E has dropped from over 20.0 at the start of this year to 16.8 yesterday.

Since about 2017, the forward P/S ratio has been boosted by the fact that the forward profit margin of the S&P 500 has been rising to fresh record highs, so earnings have been bolstered by both rising revenues and rising margins. The recent drops in both the forward P/S and forward P/E reflect fears that a recession is more likely. During recessions, revenues and profit margins tend to fall together, depressing earnings. That's not the scenario we view as most likely, but it is the one that seems to be spooking the market currently.

Note: “Forward P/S” and “forward P/E” use forward sales and forward earnings as the denominator. “Forward sales” and “forward earnings” are the time-weighted average of industry analysts’ consensus revenues or operating earnings estimates for this year and next. The time weighting removes past periods from the estimates, making a useful proxy for expected results over the next 52 weeks. The “forward profit margin” is the margin calculated from forward sales and earnings.

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