The Buffett Indicator has become a popular tool among value investors who wish to rapidly judge the relative valuation of stocks. Named for its most vocal advocate, Berkshire Hathaway (BRK.A)(BRK.B) CEO Warren Buffett (Trades, Portfolio), the indicator can help investors assess the level of overall market exuberance, a useful thing in a bull market.
The Buffett Indicator’s current message is quite stark. Having been bid up to historic – and potentially dangerous – highs, stocks appear poised for a nasty downward correction. Indeed, if the indicator is to be believed, the next crash could prove worse than that the financial crisis back in 2007-2009.
Bubble, bubble, toil and trouble
Put simply, the Buffett Indicator is the sum total of the market capitalization of all U.S. stocks relative to the nation's gross domestic product. What this means is that, when stocks overall are trading significantly below GDP, it is a buy signal. On the other hand, when stocks are collectively trading above GDP, it indicates a sell signal.
Moreover, when stocks cross above GDP, it tends to be a sign that a correction is possible. This occurred in 2000 just before the dotcom crash, and in 2007 on the eve of the financial crisis that would spark the so-called "Great Recession." The indicator proved its worth ahead of those two corrections, offering some validation to Buffett’s long-standing claim that it is “probably the best single measure of where valuations stand at any given moment."
The Buffett Indicator has proven somewhat less reliable in the current bull market. Indeed, the indicator shows that the value of stocks surged past GDP in 2013. Yet, no correction followed, as had been the case in 2000 and 2007. Indeed, stocks have continued to climb, even after even after the Buffett Indicator began flashing red in 2018 on its way to 150% last year.
On Feb. 24, the Buffett Indicator stood at a record 158.4%. Even the selloff over the past few days, driven by fears of the impact of the new coronavirus epidemic, has done little to change the misalignment. The Buffett Indicator may not be quite so eery a harbinger of immediate disaster as it was in markets past, but the sheer scale of the misalignment between the stock market and the underlying economy is cause for very serious concern.
Bubbles, bubbles, everywhere
In the U.S., the Fed has been a key driver of the bull market over the past year. Large-scale, sustained liquidity injections through the repo market, combined with a return to loose monetary policy, have driven asset prices skyward. If success breeds imitation, then these actions must be considered successful, since the central banks of most developed economies have followed the Fed’s lead in loosening monetary policy and enhancing liquidity. Unsurprisingly, this has contributed to the continuation of the broader global bull market.
Judging by the Buffett Indicator, capital markets’ bubble trouble stretches far beyond the U.S. On Jan. 10, W.E. Messamore of CCN highlighted the danger signals flashing across global markets:
“The Buffett indicator for the global stock market is in a bubble danger zone as well. As a market contributor for German newspaper Welt noticed, the indicator for global stock values hasn’t been this high since right before the Great Recession hit at the end of 2007. That’s horrifying given the Buffett indicator’s track record.”
While the Buffett Indicator may be flashing red across global markets, central banks have remained largely dismissive of the near-term risk of an asset bubble. Most recently, on Feb. 24, Bank of England chief economist Andy Haldane claimed to see no signs of a global asset bubble. Haldane is far from alone in his opinion. Indeed, Neel Kashkari of the Minneapolis Fed expressed a similar sentiment about U.S. stocks two weeks before. Yet, as I discussed in a Feb. 25 article for GuruFocus, this attitude is incongruent with the observable facts.
Bubblin’ through
While central bank economists and officials do not appear worried about the existence of an asset bubble (let alone their hand in inflating it), an ever larger number of conscientious investors have started paying attention. As stocks continue to test new highs and stretch valuations to the breaking point, the Buffett Indicator’s warning siren has turned into a veritable scream. At this point, it is hard to call the current state of the market anything other than a bubble. Investors would be wise to act accordingly.
With the Buffett Indicator showing a historic misalignment of the stock market and the underlying economy, it is hard to see much reason for stock market optimism over the next couple years. Investors should tread very carefully.
Disclosure: No positions.
Read more here:
- Recession May Turn Corporate Bonds Into Value Investor Gold
- The Fed Has Created a Bubble in Everything
- Kraft Heinz Downgrade: Canary in a Coal Mine?
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