Investors and economists have many tools and rules for measuring the temperature of the overall market. One method is to take the ratio of the total market capitalization of all U.S. stocks to U.S. gross domestic product. This particular method has come to be known as the Buffett Indicator, in honor of its leading exponent, Warren Buffett (Trades, Portfolio) of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
For years, Buffett has sung its praises as a simple tool for measuring the relative valuation of the stock market compared to the broader economy:
"It is probably the best single measure of where valuations stand at any given moment.â
As we discussed in a recent research note, the Buffett Indicator has been giving the danger signal for some time. Yet, despite having first flashed a warning in 2013, Buffett remained unperturbed for years, continuing to buy stocks and advise others to do likewise.
Buffettâs longtime optimism may at last be turning. With Berkshire hoarding cash amidst growing global economic turmoil, it appears the Oracle of Omaha sees danger ahead and is getting ready for the deluge.
That was then
Despite the Buffett Indicator signaling an increasingly overheated stock market, Buffett kept on buying stocks. In a Bloomberg interview on Aug. 30, 2018, Buffett was asked about his famous indicator. Despite hitting near-historic levels, the guruĂ did not appear worried:
âIâm buying stocks, but Iâm not buying them because I think theyâre going to go up next year. Iâm buying them because I think theyâll be worth quite a bit more money 10 years or 20 years from now. And I donât know whether theyâre gonna go up or down tomorrow, next week, or next month, or next year. I do know theyâre good businessesâŚWe keep buying as long as we find something thatâs attractive to us. An attractive business at a reasonable price. And I love it if itâs at a really juicy price, but I still keep buying.â
More recently, in his annual letter to shareholders in February, Buffett signaled that Berkshire would likely continue buying stocks throughout 2019:
âIn the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects. That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities. We continue, nevertheless, to hope for an elephant-sized acquisition.â
This is now
Things appear to have changed in Berkshire World in recent months. As we discussed in a recent research note, the insurance conglomerate has moved away from its stock-buying pattern, instead opting to hold unprecedented amounts of cash. Buffett always wants to put his money to work. The float created by Berkshireâs stellar insurance business â and by several other lucrative operating companies across the sprawling conglomerate â has been put to work buying stocks and, whenever possible, buying whole companies.
While Buffett lamented the dearth of acquisition opportunities in his most recent annual letter, he had not lost hope. Given the increasingly shaky macroeconomic environment at home and abroad, it is not terribly surprising that the investor has opted to keep his powder dry. Berkshire likes to own companies where possible. Thus, a stock market correction, or even a recession, could create a perfect opportunity for Buffett to pounce on targets that may currently be trading a bit too richly.
In many ways, that patience is one of Buffettâs strongest advantages. Because he runs Berkshire like a family business rather than as, say, a hedge fund or private equity fund, he does not feel the same pressure to make acquisitions. He can afford to be patient:
âThe stock market is a no-called-strike game. You don't have to swing at everything â you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, âSwing, you bum!ââ
Pitches are flying, but Buffett is not swinging yet.
What comes next
Berkshire is perfectly poised to take advantage of a recession to its benefit. Investors hoping for a return to Berkshireâs glory days may not have long to wait. The conglomerate's best years have been during times of panic, when Buffett had the resources to scoop up opportunities and benefit from the better information afforded to strategic partners, rather than exterior analysis.
In a follow-up research note, we will discuss how Buffett may put Berkshireâs dry powder to good use in the coming years.
The Oracle of Omaha prophesies trouble ahead. We consider that a warning worth heeding.
Disclosure: No positions.
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