Warren Buffett (Trades, Portfolio) has seen his fair share of market cycles during his more than five decades at the helm of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Over the years, he has learned a thing or two about gauging the state of the stock market.
According to Buffett, the very best metric for assessing the relative overvaluation or undervaluation of the stock market as a whole is simply to compare the combined market capitalization of all U.S. stocks to gross domestic product. Indeed, Buffett has gone so far as to call this ratio “the best single measure of where valuations stand at any given moment." Buffett has become so closely linked with this ratio that it has earned the moniker "Buffett Indicator."
Right now, the Buffett Indicator is screaming a serious warning.
Flashing redder than ever
According to the Buffett Indicator, when stocks as a whole are trading significantly below GDP, it is generally a signal that stocks are relatively undervalued. Conversely, when the market capitalization of all stocks is above GDP, it is a sign that stocks have become overvalued.
Historically, the Buffett Indicator has worked best as a signal of market overheat. When the dot-com bubble reached its zenith at the start of the 21st century, the total market capitalization of U.S. stocks was 137% of GDP. After that bubble burst, the ratio collapsed below 100% for nearly a decade. In the run-up to the Great Financial Crisis, the ratio again ticked past 100%, but topped out at about 105% before the housing bubble brought it crashing back to earth.
The pattern appears to have changed during the long economic expansion and bull market that emerged from the Great Recession. Total stock market capitalization crossed above 100% of GDP in 2013 and, rather than signaling an imminent correction and shakeout, it has continued to climb ever since. Right now, U.S. stocks are valued in excess of 200% of GDP.
Based on the Buffett Indicator, it would appear that stocks are historically overvalued. That alone might be enough to give some cautious investors pause. Indeed, the venerable market metric is now in wholly uncharted territory. That fact has, perhaps unsurprisingly, made many investors nervous. Some have even concluded that the historic disconnect between stock valuations and economic output is a recipe for disaster. Legendary value investor Jeremy Grantham (Trades, Portfolio), for example, argued last month that the historically massive bubble is destined to end in an historically severe correction. He said as much during an interview last month:
“When the decline comes, it will perhaps be bigger and better than anything previously in U.S. history.”
There may be something to this view. Historically, the bigger the bubble, the bigger the correction. The last time a market bubble burst in spectacular fashion, at the start of the 2008 financial crisis, the total U.S. stock market capitalization collapsed to 56.8% of GDP. Should the long bull market finally falter, investors may be forced to weather a similarly severe reversal.
Under current market conditions, defensive investors may opt to rebalance their portfolios in order to insulate themselves from the financial fallout that tends to accompany a major market correction. How best to do that is less clear. I recently discussed Grantham’s opinion that green investments are best positioned, both to weather the initial impact of a correction and to bounce back during the next expansion. I have also talked about financially stable dividend aristocrats as possible safe-haven stocks. There are many other strategies on offer.
Heeding the signs
As Mark Twain famously observed, “History doesn’t repeat itself, but it often rhymes.” Ultimately, investors will have to decide whether the Buffett Indicator’s current warning is worth heeding, or whether it has lost its predictive value in the modern stock market.