A long-time favorite stock market valuation indicator of legendary investor Warren Buffett is flashing OVERVALUED.
The ‘Buffett Indicator’ as it’s called in Wall Street circles — which takes the Wilshire 5000 Index (viewed as the total stock market) and divides it by the annual U.S. GDP — is at its highest level since before the internet bubble crash in 2000. Currently, the ratio of 1.7 is some 70% above its historical average of one.
Back before the internet stock crash, Current Market Valuation points out the ratio stood at 1.71 — or the market being 71% overvalued.
“Normally, this ratio is around 1, meaning that total market cap of all U.S. stocks generally equals annual U.S. GDP. When stocks are considered to be fundamentally overvalued, the ratio increases to 1.3 (so total stock market capitalization is 30% larger than U.S. GDP),” explains Sevens Report Research founder Tom Essaye.
With Fed liquidity running rampant and fueling new record highs — and the pandemic causing U.S. GDP to plunge — it’s no surprise the Buffett Indicator is flashing red.
“What does that mean for us? It means stay long stocks in longer-dated accounts, and make sure you own assets (such as a house, etc.). But it also means this asset inflation cycle better not stop, because as the 1.7 times total market cap to GDP ratio tells us if asset inflation stops, it’s a long, long way down to fundamental support,” cautions Essaye.
That said, it’s wildly unclear if this indicator being overheated means stocks are headed for a short-term crash. Remember, a market could stay overvalued for a while as long as investors believe it’s still undervalued.
All it could mean is that if one is in the position currently to pare back winning positions in the portfolio, it wouldn’t be such a bad idea.
“Part of the reason why we have paired back modestly some of our positions in equities is because of concerns about valuations here. But I would also say this is a different market than what we saw during the dot com bubble. These are companies that are making earnings and increasing their earnings. Apple is one example of that. We’re not in the same kind of extended valuation scenario we were back in the dot com bubble,” State Street Global Investors Deputy global CIO Lori Heinel told Yahoo Finance’s The First Trade.
Get more insight on Buffett’s investing do’s and don’ts here.
Brian Sozzi is an editor-at-large and co-anchor of The First Trade at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.
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