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Warren Buffett's Favorite Market Indicator Signals Trouble Ahead

The market is in a rather precarious place at present, with stocks continuing to test all-time highs even as the Federal Reserve rushes to bolster a faltering economic expansion. Despite mounting danger signs, most investors appear happy to continue ignoring the growing disconnect between capital markets and the underlying economy. However, not everyone has been complacent.


Warren Buffett (Trades, Portfolio), the legendary value investor and boss of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), has been a shrewd observer of macroeconomic and market forces for decades. Now his favorite indicator of market overexuberance is flashing danger.

Investors would be wise to heed the warning signs.

When capital markets and the economy diverge

Stocks represent ownership interests in companies that engage in economic activity. As companies grow and their profits rise, their stock goes up. Naturally, this relationship extends to the economy as a whole. Thus, asset prices can neither outpace nor lag economic growth over the long run. There is always a reversion to the mean, as GuruFocus has explained:


"Over the long run, stock market valuation reverts to its mean. A higher current valuation certainly correlates with lower long-term returns in the future. On the other hand, a lower current valuation level correlates with a higher long-term return."



Yet, despite this inevitability of a reversion to the mean in the long run, capital markets have always proven prone to extended bouts of misbehavior, as asset prices rarely perfectly align with the fundamentals of the underlying economy.

What this means is that investors have opportunities to profit from mispricing of the market as a whole, as well as mispricing of individual securities. The challenge lies in finding a suitable means of measuring misalignment between the stock market and the economy.

How Buffett measures opportunity

One method is to take the ratio of the total market capitalization of all U.S. stocks to U.S. gross domestic product (GDP). For years, Buffett has sung the praises of this simple, yet powerful, ratio:


"It is probably the best single measure of where valuations stand at any given moment."



Buffett's advocacy for this ratio has been so strong that it has come to be known as the "Buffett Indicator." As we have discussed in a previous research note, the Buffett Indicator offers a straightforward method of determining the relative alignment of the stock market and the broader economy:


"When stocks overall are trading well below GDP, then that is a generalized 'buy' signal. Meanwhile, if stocks are valued significantly higher than GDP, then stocks have been bid up beyond reasonable value. Of course, there are opportunities in either set of circumstances to find value in individual securities (even in this long bull run where everything has started to look expensive). When the aggregate U.S. market cap growth outstrips GDP growth for a lengthy period, however, it is a clear signal that market confidence is out of step with the broader economy."



The Buffett Indicator in action

In practice, the Buffett Indicator offers an asymmetric guide to relative values of asset prices. While a ratio of less than 100% may indicate that stocks are undervalued, this situation can persist for many years. The asymmetry makes intuitive and logical sense when one considers that the stock market, while reflecting a large part of total economic activity, does not capture all of it.

The indicator's greater utility is in its measurement of overexuberance. The Buffett Indicator rises above 100% only on very rare occasions. In 2000, at the height of the dot-com boom, the Buffett Indicator hit a still-record 148.5% thanks to widespread irrational exuberance driving tech stocks into the stratosphere. When the tech bubble burst, the stock market plunged and the Buffett Indicator dropped to 74%. It remained well below 100% for several years.

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The Buffett Indicator did not rise consistently above 100% again until late 2006. Topping out at 110.7% in 2007, the Buffett Indicator sagged after the housing bubble burst in spectacular fashion, sending the stock market into a tailspin. The Buffett Indicator bottomed out at 56.8% in 2009, during the bruising Great Recession that followed the financial crisis.

An unprecedented run

As the post-recession bull market got going, the Buffett Indicator rose steadily. An accelerating expansion saw the Buffett Indicator cross 100% in 2013, and it has been on a fairly steady climb ever since.

The current bull market has proven remarkably resilient. During the dot-com boom, the stock market overmatched GDP for about three years. A Buffett Indicator above 100% was even shorter-lived during the subsequent expansion, persisting for less than two years.

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This time around, things have been rather different. The Buffett Indicator has held above 100% for more than six years, a totally unprecedented stretch. At 144% as of Sep. 19, the Buffett Indicator is perilously close to the all-time high briefly witnessed in 2000.

Verdict

The Buffett Indicator rising above 100% is a rare occurrence, but also a momentous one. When market optimism turns to mania, asset prices shoot upward. And the Buffett Indicator rises with them. Such situations cannot end well, as Epsilon Theory's Ben Hunt explained in a post on Sep. 18:


"The only sustainable way to be richer than your economy grows over a sustained period without pulling forward future growth is to extract wealth from [the rest of the world]."



Given the rising levels of domestic and international macroeconomic uncertainty, faith in the stock market's ability to continue its inexorable rise appears misplaced.

Investors should tread extremely carefully in these murky market waters.

Disclosure: No positions.

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This article first appeared on GuruFocus.