Warren Buffett Indicator Flashes Code Red
Investing legend Warren Buffett’s trusted stock valuation measure is signaling that UK shares are at their most undervalued levels in over a decade and a half. But does this indicator justify diving into UK equities despite economic storm clouds gathering?
The “Buffett Indicator,” devised by the American business magnate, divides a stock market’s total value by the country’s gross domestic product to gauge whether shares are overpriced or offer bargain opportunities.
On average since 1999, this ratio for the UK market has floated around 120% – meaning stocks overall have tended to trade at valuations about 20% higher than the size of the British economy.
Today, however, the Buffett Indicator has plunged to just 90% – meaning the total value of all listed UK companies amounts to barely 90% of total British economic output last year. The last time British stocks looked so cheap by this measure was during the global financial crisis crash of 2008.
At first glance, seeing UK shares valued at just 0.9 times GDP seems to flash a glaring “buy” signal for bargain-hunting investors. Especially considering that Buffett himself described this indicator as “the best single measure of where valuations stand.”
But does this 15-year low reading truly make the case for snatching up UK stocks with both hands? Or could there be good reasons why the market remains so beaten down?
Why So Gloomy?
Much of the pessimism swirling around the UK market links back to the dismal economic prospects facing the country in 2023 and likely beyond.
While recession continues clutching much of Europe and the world economy in its grip, the UK stands out with especially gloomy projections. The independent Office for Budget Responsibility (OBR) predicts Britain faces years more economic pain before growth recovers, weighed down by rising taxes, higher interest rates, and falling real wages.
This bleak outlook of protracted stagnation pressures corporate profits and drags on share prices across British industries. Even quality companies and blue-chip giants have seen their valuations hammered down near 52-week lows recently, despite broadly resilient performances.
Take banking giant Lloyds as just one example – its stock trades barely 10% above 12-month lows currently, despite the fact that rising interest rates typically boost bank profit margins.
The disconnection between strong company fundamentals and lagging share prices underlines just how thoroughly the gloom infusing the UK economy has infected stock market sentiment.
And sentiment often overshoots fundamentals in both directions when gripped by emotion – meaning shares could fall further from justified valuation levels before recovering.
Flawed Indicator?
Beyond the UK’s deteriorating macroeconomic narrative, some fundamental flaws lurk within the Buffett Indicator itself that undermine just how effective it is at signaling clear over- and under-valuation levels.
One major critique notes that while the indicator captures the total market value of UK-listed shares, it only compares this against Britain’s domestic economic production. Yet many of the largest London-listed multinationals today earn the majority of revenues and profits overseas.
So comparing just one side of the fraction – global market values – against only UK economic output paints a partial and limited picture. It fails to account for international revenues and the global earnings potential backing up share prices.
And the fact that the Bank of England has aggressively jacked up interest rates over 14 times in the past two years further distorts the message from this indicator. As rates rise, stocks fall as investors can earn similar or better cash returns from bonds and savings accounts with less risk and volatility. Rates thus act as gravity on equity markets – but the Buffett Indicator completely ignores their fluctuation and impact.
Bargain Hunting Time?
Despite the gloomy British economic narrative and flaws inherent in this valuation measure, the sheer scale of the disconnect flagged by the Buffett Indicator still suggests UK stocks overall languish at bargain basement valuations.
While risks certainly abound and more volatility seems inevitable, valuations around just 15% above 2008 crisis lows seem to bake in unrealistic amounts of negativity. Corporate earnings remain resilient thus far, and if macros stabilize at all, shares could rebound violently.
For intrepid investors willing to withstand inevitable further shocks, the UK market appears poised for some recovery. And buying during times of peak fear often reaps the greatest rewards later, as Buffett himself noted: “Be fearful when others are greedy and greedy when others are fearful.”
With British stocks currently ranking among the most fearful and undervalued globally, the UK market offers intriguing bargains during this time of turbulence. Savvy investors who pick their moments and targets carefully could find their patience handsomely rewarded in coming years if they steel their nerves and stomach the volatility ahead.
