Wednesday, July 23, 2014

INSIGHTS FROM WARREN BUFFET'S STOCK MARKET INDICATOR


INSIGHTS FROM WARREN BUFFET'S INDICATOR OF THE STOCK MARKET.
* This chart is taken from Bloomberg but with my annotations added.
Warren Buffet has a long-term stock market Indicator that has proved to be very prescient. Basically it plots the total stock market capitalization as a percentage of U.S. Gross Domestic Product (adjusted for inflation) . This chart is from 1949-2014. When the value of the stock market is a high percentage of the U.S. GDP, stocks are deemed to be overvalued. ( I should add, high means high as compared with the preceding decade or so). On my chart, you can see this happening and the sudden drop in those years, and the events in those years.
What interests me are these points:
1. It seems that from 1995 onwards,the swings get more and more violent. Personally I attribute this to the wide-spread adoption of IT viz the Internet, global communication, and online financial transactions which really began around this date. By compressing the time frame in which things happen, i.e. instantaneous information, instantaneous communications, it creates self-reinforcing feedback loops leading to more volatility.
2. I am also curious as to whether as at 2014, we are also at a danger point, and whether the downfall will be even greater than the previous one if we go by the downtrend line. However, the past cannot be an indication of what the future will be-for the reason that the markets are Complex Adaptive Systems that continuously evolve as events unfold. The only thing we can say is that with each day that the market gets higher, the probability of it crashing is higher. For there is another property of Complex Adaptive Systems: There are critical thresholds in non-linear dynamic systems which trigger what is known mathematically as a regime change.

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