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John Engle
John Engle
Articles (175) 

Warren Buffett Seems to Be Ignoring His Own Favorite Market Indicator

Despite his ‘Buffett Indicator’ hitting a new peak, the Oracle of Omaha is still buying stocks

October 10, 2018 | About:

Warren Buffett (Trades, Portfolio) is known around the world as the doyen of value investing and his sage advice has informed the thinking of generations of investors. One might think the current stock market, which continues to test historic highs despite economic headwinds both global and domestic, would give Buffett pause. After all, how can one find bargains when prices are through the roof?

Yet the Oracle of Omaha claims to still see opportunities in stocks. Is he ignoring his own advice, or does he see something different happening in this market?

Let’s see if we can find out.

Warning signs flashing

In a previous research note, we discussed the Buffett Indicator, a simple bit of arithmetic that Buffett has pointed to on multiple occasions as his favorite indicator of when the market is overheating and stocks are expensive. Indeed, according to Buffett, "It is probably the best single measure of where valuations stand at any given moment.”

Simply put, the Buffett Indicator is derived by taking the ratio of the sum total of the market capitalization of all U.S. stocks and U.S. gross domestic product. The basic logic of the indicator is that, should stocks outpace GDP growth for too long, it will be indicative of an overheated market in which expectations have run ahead of underlying reality.

Of course, this is perhaps an overly simplistic view of things. And there are a few financial analysts who have built a number of more advanced models of the Buffett Indicator using various proxies. But one thing is certain: Right now, the Buffett Indicator is signaling an all-time high level of divergence.

Despite all that, Buffett does not appear worried. In fact, he says he is still buying stocks despite the high prices.

Buffett is still buying

Despite the high prices prevailing in the market, Buffett has consistently maintained that there are buying opportunities. In February 2017, when the Trump administration seemed to be adding more wood to an already hot market, Buffett declared that prices were still “on the cheap side” given the then-prevailing interest rate levels.

Perhaps, with rates having risen and economic headwinds mounting over the course of the past 18 months, Buffett has changed his tune? Not so, as it turns out. He was buying stocks in January, and he was still buying stocks at the end of August. That sure seems odd for the master of value investing who as always cautioned investors to be fearful when others are greedy. With greed looking pretty rampant in the market these days, why is Buffett not fearful?

Breaking his own rule?

On Aug. 30, Buffett was asked in a CNBC interview about the Buffett Indicator, and he had this to say:

“I’m buying stocks, but I’m not buying them because I think they’re going to go up next year. I’m buying them because I think they’ll be worth quite a bit more money 10 years or 20 years from now. And I don’t know whether they’re gonna go up or down tomorrow, next week, or next month, or next year. I do know they’re good businesses. And, in relation, you have to measure investments in relation to each other and your alternative for most people is fixed income, and you get 3.0% or something like that for 30 years. So would you rather invest in a company that’s earning 15 or 20% on their invested capital and compounding it, or would you rather have a 3% bond which can never earn more than 3%?”

This is an interesting point. True, there are reasons to buy stocks over bonds most of the time. But there are still times worth being cautious. It can take a long time for even a great business to recoup an investment for you, if you bought when the market happened to be irrationally exuberant. Evidently, Buffett considers the businesses he’s buying sufficiently excellent that he will not mind a correction, even a bad one. Gone are the days, apparently, of Buffett closing up shop when the market goes mad.

Not waiting for another 1974

With more than $100 billion in cash, Buffett’s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has a whole lot of dry powder. Buffett admits that he loves it when prices get whacked down so he can pick up bargains but that he is not waiting for that scenario right now:

“That creates prices that make me want to shovel out the money as fast as I can. But we’ve been shoveling out money anyway. And it’s obviously not as attractive as when I was buying in 2008 and 2009.”

Buffett is putting Berkshire’s capital to work despite high prices, and in full knowledge that the opportunities are not as attractive as they were during the last recession. But he is not willing to wait for another perfect opportunity. As he said in the August interview, he is not waiting around for a repeat of 2008 or, better still (from a buyer’s perspective), 1974:

“1974 was the best year for buying securities in my lifetime. That’ll happen from time to time, but you can’t sit around and wait for it. You’re never gonna catch the bottom anyway and everyone will be terrified at that time."

Verdict

Despite his apparent lack of fear at current market prices, Buffett has hardly lost sight of his roots:

“We keep buying as long as we find something that’s attractive to us. An attractive business at a reasonable price. And I love it if it’s at a really juicy price, but I still keep buying.”

We respect that attitude and, with a sufficiently long time horizon wedded with a good eye for great companies, that should be all that is necessary even in today’s rarefied stock market. But many investors, even patient value investors, cannot wait forever.

There is reason to be cautious in these uncertain times. Buffett can afford to play a longer game. But there are perhaps fatter gains to be had keeping powder dry and knowing when to play defense.

Disclosure: No positions.

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About the author:

John Engle
John Engle is President of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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Comments

stephenbaker
Stephenbaker - 1 week ago    Report SPAM

Berkshire is sitting on $100 billion and generates more free cash flow than it can invest. Buffett only cares about long term results. Accordingly, no matter when another severe downturn may happen which affords a better buying opportunity, there will be plenty of cash available for Berkshire to invest at that time in any event. With that in mind, why wait? That said, if equity prices continue to rise along with interest rates, at some point a case could be made for investing in bonds. We are nowhere near that point today.

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