How to Forecast a Market Downturn like Warren Buffett

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No-one can predict the movements of the stock market in the near future. But it is possible to forecast how it will evolve long-term. In fact, this is precisely what Warren Buffett does for a living and he has taught us how to forecast

And it tells us that our investments are at risk.

As an investor, you want to generate money from your investments but more importantly you want to stick to the #1 rule of investing which is to not loose money.

Regardless, you invest in the stock market, either picking individual stocks or investing in an broader index not knowing what the future will look like. Having the ability to predict how the stock market will evolve tomorrow is impossible, but you trust that it will eventually go up.

Even if it takes 13 years like the S&P500 did between 2000 and 2013. I like to be an optimistic and a long-term investor, but anyway you look at it, waiting thirteen years to see the market go up is a darn long time.

Timing the market like Buffett

Despite all odds, in 1999 Warren Buffett successfully called the bubble of 2000 and the subsequent crash during an interview with Fortune magazine. Check out the article if you’re not familiar with it, it’s a classic.

Then in 2011, in another Fortune magazine article, he explained how he gauges the stock market’s future return. What he calls his ‘yardstick’ is the ratio of Total Market Capitalization / GDP, which to him is the ‘single best measure’ to estimate the under/over-valuation of the stock market.

Warren Buffett’s yardstick is one of the best indicators of future market returns

What Warren Buffett didn’t say, and what I found out only recently, is that this measure is highly correlated with the future stock market returns over the next 10 years.

In fact, Warren Buffett’s yardstick is one of the best indicators of future market returns with a correlation of 80% – 90% depending on the time period chosen.

It is also the easiest to calculate. You can get the latest data here from FRED or here from Gurufocus or make you own calculation with Willshire 5000 data and US GDP. It is definitely the ‘single best measure’.

Buffett’s favorite indicator

Let’s see how this indicator looks like, as it show the ratio between the Total US Stock Market Capitalization over the US GDP, from 1950 to 2015.

Total US Market Cap divided by US GDP
Total US Market Cap divided by US GDP (1947-2015)

The values oscillate between 40% and 160%, with an average around 70%.

In periods of overvaluation, like the 1960s – 1980s, the stock market increases much faster than the US GDP, for a long time period. After a sustained overvaluation, returns aren’t exciting.

When the indicator shows stock market undervaluation, opportunities appear like in 1980 with the longest bull run in history, 20 years long, from 1980 to 2000.

In 2000, the indicator was at its highest around 160%, highlighting the bubble, before the market came down 50%. The 2000 overvaluation was so extreme that annual returns for the next 10 years was -4%. A negative annual return over 10 years! Investments made in 2000 only recovered their values after 13 years.

See the chart below for an historical view on the 10-year returns of the S&P500. The highs and low are clearly matching the lows and high of the previous graph.

SnP 10y returns
S&P500 10-year returns (1950-2005)

Forecasting future market returns

Now let’s put them together and see how much correlation there is between the two. Since  the two move in opposite directions (overvaluation leads to low returns and vice-versa), we will benefit from ‘inverting’ one of the sources for visualization purposes (here : Market Cap/GDP is inverted).

Market cap gdp vs 10y returns
Market Cap / GDP and S&P500 10-year returns (1950-2015)

Pretty tightly connected, isn’t it? It actually represents an 80% correlation.

Now let us consider for a minute that the correlation will actually hold true in the future, for the next 10-years. In that case, we would already know that the expected returns should be, since we already have the Market Cap / GDP values.

Even if this is a rough estimate, it would mean that the expected returns over the next 10 years would be around 0%. I added the forecast in blue in the graph below.

Market cap gdp vs 10y returns forecast
Market Cap / GDP and S&P500 10-year returns + Forecast (1950-2015)

A 0% annual return average over the next 10 years isn’t exactly a great investment. In comparison, the 2% on the government bonds looks sexy.

Only when the tide goes out do we see who’s been swimming naked

I have written earlier on the potential for the stock market to crash now and how after the Fed’s party will be over, we risk having unrealistic expectations of future returns.

As Warren Buffett once said “Only when the tide goes out do we see who’s been swimming naked”.

What is interesting now is what happens when we plug this data back into actual S&P500 data and make a 10-year projection in the future.

A preview of the S&P500 future

What would be the a possible future for the S&P500 over the years 2015 to 2025? Let’s see how the S&P500 up to November would need to behave for the next 10 year to remain consistent with Buffett’s yardstick calculation of Market Cap / GDP.

Forecast snp500
S&P500 Forecast for the years 2015-2025

What goes up must go down and if his yardstick remains as indicative of future returns as it has over the last 60 years, investors should expect dismal returns. Maybe not 0% but something along those lines. In other words, less than the return on cash in a Savings Account.

In that scenario, the news in December 2025 might very well read:

“This December 2025, investors are rejoicing and getting ready for a Merry Christmas. The S&P500 is once again testing the 2000 points level, a level that hasn’t been reached since … 2015”.

-Nick

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5 COMMENTS

    • Hi Steve – Sorry that wasn’t meant to be scary, but yes I agree this would be quite a shock to some folks if it turns that way.
      For others, it will be an opportunity to buy stocks on sale! 🙂

    • Investing in oil isn’t necessarily a bad idea if you have 3-4 years to wait for a recovery.

      Considering that I don’t have a crystal ball, at this point this is just speculation, but what you could do is… just nothing. If you already have automatic investments in index funds, keep the contributions going.
      It will eventually average out with the recent gains and if you have another 20 years ahead of you, you will still be ahead of anyone who hasn’t invested. It is possible that after a 10-year flat market, there will be a bull market for another 10 years and you’ll get everything back and more. Plus, you still get the dividends of about 2% on the S&P500.

      What I am doing right now is that I stopped my contributions in the stock market and I switched to real-estate instead.
      It works for me because the returns on rentals in Texas are quite interesting and the interest rates are still low. Prices are also going down slightly, which helps. I have a little more cash than needed at hand and ready to be dumped in the stock market if it crashes, or serve as a downpayment for another rental.

      Hope that helps!

      • “Do Nothing” is usually my market mentality. If you’re in the market, you’re in it for the long haul. Though the constant talk of oil tanking here in Alaska is starting to make an energy index fund or something more attractive… we’ll see if I’m ever willing to invest anywhere but total index funds. 🙂

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