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The Buffett Indicator suggests that U.S. stocks may be overvalued.
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This index was coined by Warren Buffett and measures the total market capitalization of the United States relative to GDP.
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“If it gets close to 200 percent — as it did in 1999 and part of 2000 — you’re playing with fire,” Buffett said in a 2001 Fortune article.
Warren Buffett Preferred Stock Market Evaluation Index It just hit a record high, suggesting that the stock may be significantly overvalued.
The Buffett Index, which measures the total market value of U.S. stocks relative to U.S. gross domestic product, hit an all-time high of 200% on Monday, surpassing the record high of 197% set in November 2021.
In other words, the total market capitalization of the U.S. stock market, which is about $55 trillion, according to the Wilshire 5000 Index, is about twice the size of the annual U.S. GDP, which is about $27 trillion.
The stock market experienced a painful year-long bear market shortly after the Buffett Index peaked in November 2021.
in Article in Fortune Magazine in 2001, “This indicator is probably the single best measure of where valuations stand at any given moment,” Buffett said.
When the index hit an “unprecedented high” during the dot-com bubble in 2000 at about 190%, “that should have been a very strong warning signal,” Buffett said in the article.
“To me, the message of this chart is: If the percentage drops to the 70% to 80% area, you’re probably going to be very good for you to buy stocks. If it gets close to 200% — as it did in 1999 and part of 2000 — you’re playing with fire,” Buffett said.
Now, by 2024, investors appear to be playing with fire.
In a note on Thursday, Paul Dietrich, a strategist at B. Riley, pointed to the record-breaking reading in the Buffett Index as a reason for investors to We should be careful about stocks.
In a conversation with Business Insider this week, fund manager Chris Blomstran of Semper Augustus said that while the Buffett Index is a somewhat flawed tool, it’s worth paying attention to as an investor.
“I think there’s merit to that, and it’s likely to be a reversion to the mean, and there’s validity to that,” Blomstran said.
However, investors need to apply an “uptrend channel” to the index to account for changes in today’s economy compared to the economy in previous eras.
The US economy is structurally different now than it was a few decades ago, with higher corporate profit margins, more asset-light companies through the technology sector, a more globalized economy, and vastly different levels of interest rates and inflation.
“So if earnings are higher, profit margins are higher, and of course the price you pay for earnings, the price-to-earnings multiple, if you keep the price-to-earnings multiple constant, you apply it to higher profit margins, so that will raise your market cap relative to GDP,” Blomstrin explained.
“You can’t say that today’s market is comparable to the market in 2000 and the market in 1929 because those metrics were very different in those different time periods,” Blomstran added.
But despite the Buffett indicator’s flaws, it sends a big warning signal to stock market investors at current levels, according to Blomstran.
“I think the cap-weighted stock market, the Wilshire 5000 and the S&P 500, are incredibly risky today. I think owning the S&P 500 in a cap-weighted environment means you’re in trouble,” Blomstran said. “It’s definitely a long-term peak.”
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