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Testing Wilshire 5000/GDP as Stock Market Predictor

| | Posted in: Economic Indicators, Technical Trading

Is the Buffett Indicator, the ratio of total U.S. stock market capitalization (proxied by Wilshire 5000 Total Market Full Cap, W5000) to U.S. Gross Domestic Product (GDP), a useful indicator of future U.S. stock market performance? W5000/GDP clearly has no stable average value over its available history (see the first chart below), so using the level of the ratio as a predictor is not reasonable. To investigate, we therefore consider several variables based on W5000/GDP as predictors of W5000 returns at horizons up to two years, including:

  1. Quarterly change in W5000/GDP.
  2. Average quarterly change in W5000/GDP over the past two years (eight quarters).
  3. Average quarterly change in W5000/GDP over the past five years (20 quarters).
  4. Slope of W5000/GDP over the past two years.
  5. Slope of W5000/GDP over the past five years.

We consider two kinds of tests: (1) a linear test that relates past changes in these variables to future W5000 returns up to two years; and, (2) a non-linear test that calculates average next-quarter W5000 returns by ranked fifths (quintiles) of past changes in these variables. Using quarterly levels of W5000 and quarterly GDP lagged by one quarter to ensure availability during the first quarter of 1971 (limited by W5000) through the third quarter of 2020, we find that:

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