This strategy is a market timing strategy based on Warren Buffett's valuation metric ratio of total US stock market capitalization to GNP.
In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that
"The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment".
He further went on to say
"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire".
Such a simple yet elegant metric could be implemented in several ways. This strategy characterizes the valuation into the following five categories:
- Significantly Overvalued (SO): such as if the ratio >= 115% .
- Modestly Overvalued (MO): such as if 90% <= ratio < 115% .
- Fairly Valued (FV): such as if 75% <= ratio < 90% .
- Modestly Undervalued (MU): such as if 50% <= ratio < 75% .
- Significantly Undervalued (SU): such as if ratio < 50%.
These five categories are determined by four valuation parameters (such as 115%, 90%, 75% and 50% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what category the US stock market valuation is and then does the following rebalancing:
- SO: 0% in stock, 100% in cash.
- MO: 25% in stock, 75% in cash.
- FV: 50% in stock, 50% in cash.
- MU: 75% in stock, 25% in cash.
- SU: 100% in stock, 0% in cash.
Users could adjust the valuation parameters to get an effect such as only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:
- SO: >=115%, MO: [90%, 115%), FV: [75%, 90%), MU: [50%, 75%), SU: <50% .
- SO: >=115%, MO, FV, MU: [50%, 115%), SU: <50% .
Similar Strategies in ValiFi:
- Market Timing Rule with Short Term Interest Rate: using the short-term interest rates as an indicator
- Market Timing Rule with Maturity Spread: using the spread of long-term and short-term interest rates as an indicator
- SMA Timing Method proposed by Faber: using the SMA of the target asset as an indicator
- High Yield Bond Timing Strategy: using trend triggers (percentages from recent high or recent low) of the asset price for buy and sell decisions
- The 125 05 Timing Model of High Yield Bond Strategy by Gerald Appel: using predifined trend triggers (percentages from recent high or recent low) of the asset price for buy and sell decisions
- Market Timing Rule with Long Term Interest Rate: using long-term interest rate as an indicator
- Market Timing Rule with Earning to Price Ratio: using the E/P ratio as an indicator
- Market Timing Rule with Dividend Yield: using the dividend yield as an indicator
- Market Timing rule with Implied Volatility Index : using the implied volatility index as an indicator
- Market Timing Rule with Bond-Equity Yield Ratio : using the bond-equity yield ratio as an indicator
- Market Timing Rule with Dividend Payout Ratio : using the dividend payout ratio as an indicator
- Market Timing Rule with Credit Spread : using the credit spread as an indicator
- Market Timing Rule with Put/Call Ratio: using the put/call ratio as an indicator
- Learning Market Timing Rule: following the most profitable rule of the above simple market rules in each period
- Voting Market Timing Rule : Switching the position if a certain percentage of the above simple market timing rules intends to do so.
See Also
- Carol Loomis, "Buffett's metric says it's time to buy", Fortune, February 4, 2009.
- Warren Buffett and Carol Loomis, "Warren Buffett On The Stock Market", Fortune, December 10, 2001.
- John Hussman, "The Likely Range of Market Returns in the Coming Decade", Hussman's Weekly Commentaries, February 22, 2005.
- Gurufocus, "Where Are We with Market Valuations?", gurufocus.com.