By Jake Willms, Quantitative Analyst
One of the biggest challenges investors face when building a portfolio is predicting the future. Positioning yourself to be in the optimal allocation for what is on the horizon is every investor’s dream – and rightfully so. Doing this consistently over time is a sure way to generate alpha and minimize drawdowns, which are both pillars of a stable and reliable portfolio strategy. So, how can investors pursue this goal?
Indicators, which are mathematical calculations used to identify signals and trends for a particular security or market, are one of the best tools available to investors trying to prepare for future market shifts. One of the key strengths of an indicator is flexibility – since there are so many different ways to design a market indicator, investors have a near infinite number of potential indicators available to them. Indicators are often times used by investors to adjust asset allocations to respond to current market conditions and position portfolios optimally.
This vast degree of customization has led to some truly inventive indicators that have risen to popularity amongst investors. In particular, the “Buffet-Indicator” is of great renown. This measure is defined as total stock market cap divided by total GDP, a simple calculation used to assess the accuracy of stock valuations. When the Buffett-Indicator is more than 100%, it is suggesting stocks are being overvalued. The opposite is also true – when the Buffett-Indicator is less than 100%, stocks are considered undervalued.
Earlier this week, the Buffett-Indicator soared to a 30-month high, reaching values above 100% and sounding the alarm to investors that global stocks are overpriced. This spike highlights the ongoing rise in stock valuations in relation to the depressed economic growth in many countries around the world, thanks in large part to COVID-19.
If the Buffett-Indicator is right, then stocks are considerably riskier today than they were just a few short years ago. Valuation risk can creep up on investors in the background, especially those with fixed asset allocations, such as a 60/40 stock-to-bond ratio. As valuation risk increases, so does the risk of holding stocks in your portfolio, and as a result you may wish to consider adjusting your asset allocation to accurately match your risk tolerance.
No market indicator is perfect. Trying to predict the future, especially with investing, is a losing game, and the Buffett-Indicator is no exception. Using past quarter’s GDP can create noise when comparing it to current valuations. In addition, there’s even more concern when looking at global markets because not every country provides timely and accurate GDP data. Moreover, stocks have benefited in large part from government stimulus packages aimed to bail out banks and preserve market stability, while economies around the globe have struggled from the temporary closure of non-essential businesses and the side effects of social distancing.
Indicators must strike a balance between accuracy and timeliness, and often times this is a tall order to fulfill. Accurate indicators are slow and may not produce information in time for an investor to act, while a fast and responsive indicator may create noise that can confuse or mislead investor decision-making. Still, indicators have a lot of value to bring to table, and are no doubt one of the best tools we have available to position ourselves for what the future has in store.