Buffett's Ratio Says Stocks Are Getting Interesting

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."

There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."

He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."

Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.

Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.

Source: Dow Jones, St. Louis Fed, author's calculations.

Understand what this does not mean:

• It does not mean stocks are bound to go up in the short run. No metric can predict that.

• It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.

And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.

But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:

Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.

There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favor. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. In recent articles and discussions, fellow Fools have pointed out Waste Management (NYS: WM) , Wells Fargo (NYS: WFC) , Cisco (NAS: CSCO) , EMC (NYS: EMC) , and Costco (NAS: COST) -- among others -- as opportunities we're excited about after the slump.

"The lower things go, the more I buy," Buffett said last week.

How about you?

At the time thisarticle was published Fool contributorMorgan Houselowns no shares mentioned above. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of Costco Wholesale, EMC, and Waste Management. The Fool owns shares of and has created a bull call spread position on Cisco Systems. The Fool owns shares of and has created a ratio put spread position on Wells Fargo.Motley Fool newsletter serviceshave recommended buying shares of Costco Wholesale, Waste Management, and Cisco Systems. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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