The stock market has had quite a run in the last couple of years. Since January 2, 2009, the S&P 500 has gained 52%, and a good chunk of what the market lost in the Crash of 2008 has since been made back. This is good news, right? Certainly, many regular investors are starting to think about investing in stocks again. Is it a good idea?
Common sense tells us that it’s best to buy low and sell high when investing. The stock market, however, tends to run counter to this logic. When the stock market is rising, people often feel that they need to get in quickly before it goes up more. They worry that they’re missing out on possible gains. The problem is, by the time the stock market reaches this point, most of the gains have already happened, and there often isn’t that much upside left. This presents a danger for people just getting into the market.
What can we do about this? Warren Buffett, arguably the most successful stock market investor to date, has proposed an easy way to look at the overall market and see how high stock prices have become relative to the worth of the companies represented in the market. It’s called the “Market-to-GDP” ratio. This ratio takes the price of the overall stock market (for argument’s sake, we’ll use the Wilshire 5000 Total Market Index for this), and compares it with the current output of most of its constituent companies, the United States Gross Domestic Product (GDP). (Although Mr. Buffett actually proposed using GNP, Gross National Product, the GDP figure is more widely used today, and generally tracks GNP within one percentage point.)
Historically, stock market returns have been reasonable, or better than the “risk-free” return of short-term government bonds over time, if the Market-to-GDP ratio falls below 0.9, or 90%. Yesterday, the Wilshire 5000 closed at about $13,886 billion. The last reported real GDP figure was $14,861 billion. This makes our ratio about 93%. The stock market might be slightly expensive as an investment right now, and it might be a good idea to wait until GDP increases or the stock market goes down a bit before investing. This may especially be true if you primarily invest in index funds that track the overall market, rather than individual stocks (or other investments).
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