Testing Wilshire 5000/GDP as Stock Market Predictor

Is the Buffett Indicator, the ratio of total U.S. stock market capitalization (proxied by Wilshire 5000 Total Market Index 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 the level of the ratio is not a useful predictor. We therefore consider the following variables based on W5000/GDP as predictors of W5000 returns at horizons up to two years:

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 relating past changes in these variables to future W5000 returns up to two years; and, (2) a non-linear test calculating average next-quarter W5000 returns by ranked fifths (quintiles) of past changes in these variables. Using quarterly levels of W5000 (with extension), Shiller’s P/E10 lagged by one quarter and quarterly GDP lagged by one quarter during the first quarter of 1971 through the first quarter of 2024, we find that: (more…)