The SPDR S&P 500 ETF Trust (NYSE: SPY) was up another 1% on Wednesday to new all-time highs, while the underlying U.S. economy continues to struggle with a COVID-19-driven recession.
The disconnect between the health of the economy and the bullish momentum in the stock market has baffled some investors, and one of the preferred valuation metrics used by Berkshire Hathaway, Inc (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett suggests the stock market is currently extremely overvalued.
What Is The Buffett Indicator? The so-called “Buffett indicator” is also known as the market capitalization-to-GDP ratio. The metric earned its nickname after Buffett once said it's “the best single measure of where valuations stand at any given moment.”
The Buffett indicator is calculated by dividing the total value of all stocks in the U.S. market and by the gross domestic product of the U.S. Traders typically use the Wilshire 5000 Total Market Index as a measure of total U.S. market cap.
His famous quote comes from a 2001 Forbes article in which Buffett discussed investing strategy. In the interview, Buffett was discussing a long-term chart of the Buffett indicator such as the one below.
"The chart shows the market value of all publicly traded securities as a percentage of the country's business — that is, as a percentage of GNP,” Buffett said. “The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.”
Where Is It Now? Historically, the Buffett indicator average has been between 93% and 114%. The ratio peaked at 107.5% at the peak of the housing bubble in 2007 and at 139.5% during the dot-com bubble in 2000. In 2020, the Buffett indicator has spiked to new all-time highs of 182.7%, and it continues to climb higher with each new stock market high.
The good news for investors is that there are limitations to what the indicator means about the stock market. The indicator isn't a sign of an imminent market sell-off, as suggested by the fact it has been historically high for several years now.
What Does It Mean? How should investors think about the fact that the Buffett indicator is currently making all-time highs? Buffett addressed the previous indicator peak back in 2001.
“Nearly two years ago, the ratio rose to an unprecedented level. That should have been a very strong warning signal,” he said.
Brad McMillan, CIO of Commonwealth Financial Network, recently discussed the implications of new record highs for the Buffett indicator.
“Once you get above the highest levels of previous history—which in both cases are those of the dot-com boom—you have to ask how much higher you can get,” McMillan said.
“All-time highs are great, and they often lead to further highs. But they can also signal increased risk.”
Benzinga’s Take: Even if the stock market is overvalued, it doesn’t mean a sell-off is imminent. However, it does mean that investors should keep that stretched valuation in mind when assessing risk and balancing a portfolio accordingly.
Image credit: Fortune Live Media, Flickr
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