Bank of America isn't sure one of Warren Buffett's favourite stock market indicators should really make you nervous

The Oracle of Omaha is facing some opposition.

In a note to clients on Monday, Bank of America Merrill Lynch’s Savita Subramanian wrote that Warren Buffet’s favourite metric of long-term value “may have limited utility.”

The market cap to GDP ratio, which has been popularised by Buffett, is used to determine whether the stock market is overvalued or undervalued.

And given that this measure shows the S&P 500 is 80% above its historical average level, some might find signals from the market cap to GDP ratio concerning. But BAML is sceptical about how good of a measure it actually is of the stock market’s value.

Subramanian points to three main reasons why the metric is not one of BAML’s favourite for valuing equities:

  1. Market Cap/GDP is like Price/Sales, “with all of its shortcomings and more.” BAML adds that neither measure takes structural changes in profit margins into account, which is problematic. In 2014 corporate margins grew to new highs due to lower taxes, lower interest expense, and higher operating margins in tech.
  2. Global GDP should be used because it is more closely tied to the S&P 500 than US GDP. This is because S&P companies are generating more and more sales and profits from overseas, not just in the United States.
  3. There are too many mix differences between the US equity market and the entire US economy. For example, sectors like technology and energy hold a much stronger weight in the stock market than they do for US GDP. Also, US GDP is more services-oriented, while profits from S&P companies are more goods-oriented.

Here’s what the Market Cap to GDP ratio has looked like since 1964:

And so this measure currently makes the stock market look expensive, but at least in BAML’s view, there are plenty of reasons not to worry about something that might have the world’s most famous investor concerned.

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