Can Warren Buffett Forecast Equity Market Corrections?

Abstract

Warren Buffett suggested that the ratio of the market value of all publicly traded stocks to the Gross National Product could identify potential overvaluations and undervaluations in the US equity market. We investigate whether this ratio is a statistically significant predictor of equity market corrections. We find that the static decision rule suggested by Buffett does not deliver satisfactory forecasts. However, when we adopt a time-varying decision rule, the ratio becomes a statistically significant predictor of equity market corrections. This new decision rule is robust to changes in its key parameters: the confidence level and the forecasting horizon.

Keywords: stock market crashes, equity markets, market value-to-GNP ratio, equity market, GNP, GDP, likelihood ratio test, Monte Carlo

JEL Classification: G14, G15, G12, G10