Market Overview

The 'Buffett Indicator' Says Stocks Are More Overvalued Now Than Before Dot-Com Bubble Or Great Recession

The 'Buffett Indicator' Says Stocks Are More Overvalued Now Than Before Dot-Com Bubble Or Great Recession

After more than nine years of mostly uninterrupted bull market gains, some investors are getting understandably concerned about just how expensive U.S. stocks have gotten. According to financial metric that is a favorite of Wall Street guru and Berkshire Hathaway Inc. (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett, investors are right to be concerned.

In fact, after Buffett once called the metric “the best single measure of where valuations stand at any given moment,” investors have begun referring to the calculation as the “Buffett indicator.”

What Is The Buffett Indicator?

The Buffett indicator is a relatively straightforward calculation: it’s the total market cap of the U.S. stock market divided by U.S. GDP. Investors can use different variants to estimate the value of the U.S. market, but all of them are flashing some disturbing signals at the moment. The chart below highlights where the Buffett indicator peaked prior to the bursting of the dot-com bubble and the 2008 Great Recession.

Using the Wilshire 5000 as the market cap benchmark, the Buffett indicator is currently sitting at above 138 percent. During the housing market bubble prior to the financial crisis, the Buffett indicator peaked at just 105.2 percent. During the dot-com bubble, it peaked at just 136.9 percent. The Buffett indicator hasn't approached 100 percent at any other time in the last half century.

What Does It Mean?

Buffett himself has recently expressed his trademark optimism about the near-term outlook for the U.S. economy, but the Buffett indicator and a number of other metrics suggest stocks are historically expensive. Of course, with interest rates still near historically low levels, investors still have few viable alternatives to the market, a phenomenon that has helped drive the market rally.

The Buffett indicator also has limited predictable value and is simply a reflection of how expensive stocks are relative to history. Financial bubble expert and Nobel laureate Robert Shiller says identifying a bubble and determining when it's going to pop are two entirely different feats.

Last year, Shiller referenced the cyclically-adjusted price-to-earnings (CAPE) ratio as another long-term value metric that indicates stocks are historically expensive, but he warned investors not to make assumptions about what that may or may not mean in the near-term.

“We can't time the market accurately, but we know that when it's this high, over the long term, it usually doesn't do great,” Shiller said.

CAPE Concerns

At the time of Shiller’s comments, the S&P 500 CAPE was at around 28.6, well above its historical mean of 16.8 and at its highest level since it peaked at 44.1 during the height of the dot-com bubble in 1999. The S&P 500 CAPE has since expanded to 33.1, exceeding even its peak level prior to the Great Depression.

The stock market has so far shown no signs of slowing down in 2018. The SPDR S&P 500 ETF Trust (NYSE: SPY) is up another 6.6 year-to-date.

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