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Can Warren Buffett Also Predict Equity Market Downturns?

Can Warren Buffett Also Predict Equity Market Downturns?

H/T Alpha Architect

NEOMA Business School

William T. Ziemba

University of British Columbia (UBC) - Sauder School of Business

July 26, 2015

Abstract:

In a 2001 interview, Warren Buffett suggested that the ratio of the market value of all publicly traded stocks to the Gross National Product could identify potential overvaluations and undervaluations in the US equity market. In this paper, we investigate whether this ratio is a statistically significant predictor of equity market downturns.

Can Warren Buffett Also Predict Equity Market Downturns? - Introduction

Pointing to the spectacular rise in the level of the S&P500, which has more than tripled since the March 9th, 2009 trough and rose nearly 40% in 2013 and 2014 alone, investors and pundits worry that the US equity market might be dangerously overvalued. In fact, legendary investment manager George Soros already entered a $2.2 billion put position on the U.S. stock market as early as August 20141. Is the U.S. equity market about to crash?

In an attempt to answer this question, investors and pundits have turned to a variety of measures, ranging from Nobel laureate Robert Shiller's Cyclically-Adjusted Price-to-Earnings (CAPE) (Campbell and Shiller, 1988, 1998; Shiller, 2006, 2015) to Warren Buffett's ratio of the market value of all publicly traded stocks to the current level of the GNP (MV/GNP) (Buffett and Loomis, 2001). In this paper, we investigate whether the MV/GNP ratio is an accurate predictor of equity market downturns...


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