Warren Buffett’s Favorite Market Gauge Has Blown Past a Level He Once Called a Warning. History Says This Comes Next.
“You are playing with fire.”
Warren Buffett used those five words to bluntly warn investors in a 2001 Fortune article. He preceded the warning with a discussion of his favorite market gauge, the ratio of total stock market capitalization to gross national product (GNP). This metric became popularly known as the Buffett indicator.
The “Oracle of Omaha” wrote in the article that when the total stock market capitalization-to-GNP ratio “rose to an unprecedented level” nearly two years earlier, it “should have been a very strong warning signal” to investors. And he used the “playing with fire” language to describe the scenario when the market valuation gauge approaches 200%.
The Buffett indicator has now blown past that 200% level. History is crystal clear about what’s likely to come next.
Warren Buffett. Image source: Getty Images. Image source: Getty Images.
The Buffett indicator’s potentially dangerous surge
Buffett initially used GNP in the market valuation indicator that now bears his name. Over time, though, gross domestic product (GDP) replaced GNP. The two metrics both track a country’s economic output. However, GNP reflects the value of all finished goods and services produced by a country’s citizens, wherever they are, either at home or in another country. GDP only includes the value of the finished goods and services produced within a country’s borders.
GNP and GDP track closely enough that it doesn’t matter which one is used in the Buffett indicator. For example, the U.S. GNP today stands at $32,559,355,000,000, while the U.S. GDP is $32,563,030,000,000. A difference of around $3.7 billion doesn’t matter much when both figures top $32.5 trillion.
Whichever economic metric you use, the Buffett indicator has surged to an all-time high. Using the Wilshire 5000 index as a proxy for total U.S. stock market capitalization, Buffett’s favorite market gauge now hovers near 237%.
History’s brutal lessons
The Buffett indicator has risen significantly above its long-term moving average three times over the past 100 years. The first instance was in the late 1920s. What happened next? The stock market crash of October 1929.
Buffett alluded to the second example of the ratio of total U.S. stock market capitalization to GNP surging in his 2001 Fortune article. In the late 1990s, the valuation metric hit an all-time high.
Soon afterward, the stock market plunged as the dot-com bubble burst. It took years for the S&P 500 (^GSPC +0.60%) to regain its previous high.
The third case isn’t quite as dramatic as the first two, but the pattern is still there. In late 2021, the Buffett indicator approached 200%. Were investors “playing with fire” then, as Buffett warned two decades earlier? Yep. The S&P 500 entered a bear market only weeks later, with the index sinking 19% the following year.
Three things investors can do
With Buffett using an analogy of fire, you might think that the smartest move is to get away from the fire altogether. In practical terms, that would mean selling all of your stocks and staying on the sidelines.
However, that isn’t what Buffett is doing. He’s still Berkshire Hathaway‘s (BRKA -1.44%) (BRKB -1.01%) single biggest investor. He has been involved in the conglomerate’s investing activity this year. And Berkshire still has hundreds of billions of dollars invested in stocks.
What should investors do if running for the hills isn’t the best option? The first and simplest approach is to wait. Over the long run, the stock market generates positive returns.
Second, investors can build cash to be in a position to take advantage of a potential stock market downturn. Buffett has been doing this for a while, as evidenced by Berkshire’s cash stockpile of nearly $385 billion.
Third, investors can buy stocks that are likely to successfully navigate market turbulence. Some healthcare stocks, for example, tend to hold up well even when the overall market declines.
Finally, it’s important to remember that history doesn’t always repeat itself. Just because the stock market has fallen sharply on previous occasions when the Buffett indicator rose to elevated levels doesn’t necessarily mean that it will do so this time. But it doesn’t hurt to be prepared just in case.
Source: www.fool.com — article syndicated from the publisher’s feed; all rights remain with the original publisher.