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The Warren Buffett Indicator Is Ringing the Alarm to Sell

Trisha Sebastian

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Warren Buffett, Chairman Salomon Brothers, testifies before U.S. House Subcmte. on Telecommunications-Buffett Indicator-ss-featured

The Buffett Indicator is sounding the alarm, and it’s more air raid siren than a gentle reminder. Famed investor Warren Buffett’s famous metric is nervously monitoring the stock market situation, and it’s not a pretty sight. Currently, the US market cap is more than double the level of estimated GDP for the quarter. This means the ratio between the two surged to its highest-ever readings. This suggests a strongly overvalued situation. 

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The Buffett Indicator 

The “Buffett Indicator” is a simple ratio. It measures the total US stock market capitalization divided by the total dollar value of the US Gross Domestic Product. Buffett himself called the metric “the best single measure of where valuations stand at any given moment.”

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A high ratio indicates an overvalued market—and as of February 11, 2021, the ratio has reached all-time highs, indicating that the U.S. stock market is currently strongly overvalued. The latest reading of the Buffet Indicator is 189.5%, which is higher than the previous high of 176.6% from the previous quarter. The reading is based on the Q4 GDP second estimate and the February close data. 

Meanwhile, the latest worldwide reading recently breached 123%, surpassing its previous record of 121% during the dot-com bubble. This means stocks are overpriced as well outside the US, but none are as overvalued as here. 

‘Be Fearful When Others Are Greedy’

After the early 2000s dot-com bubble, the Buffet Indicator’s alarm bells lit up again in 2019. While Warren Buffett’s catchphrase “Be fearful when others are greedy” applies to the current trend, other investors think the opposite. A lot continues to pile money into stocks, and seem to listen to the “the trend is your friend” mantra instead. 

Meanwhile, investors are in a buying mood in the US. Awash with cash due to fiscal stimulus along with a record year for savings, many are putting money into the market. The Federal reserve’s decision to hold interest rates near zero also helps. In addition, the Fed also undertook a bond-buying spree. All these factors can possibly lead to stellar growth in the GDP and inject more into corporate earnings. 

Possible False Alarm

Given the US market’s remarkable position, some analysts think that the Buffet Indicator might be sending false alarm signals. The situation “highlights the remarkable mania we are witnessing in the US equity market,” noted Michael O’Rourke, chief market strategist at JonesTrading. “Even if one expected those (Fed) policies to be permanent, which they should not be, it still would not justify paying two times the 25-year average for stocks.”

This detachment of the Buffett indicator from its long-term trend joins an assortment of other valuation metrics. Many metrics already exceeded their previous records during the recent stock market rally during the pandemic. Price-to-earnings, price-to-sales, and price-to-tangible-book value are some of the over-the-top readings on top of dot-com bubble levels. Before, investors saw these are once-in-a-lifetime occurrences. Now, many investors see them regularly. 

S&P 500 Valuation Metrics Are Rising

Meanwhile, many analysts believe that rising valuations are not the best tools for timing market tops. Given the pandemic, investors are banking that valuations will continue to rise. For example, the S&P 500 picked up 1.2% as news on increasing vaccination rates and a nearing deal on a stimulus package. Energy led the sectors in rising as it anticipates renewed demand.   

“When you compare it to fixed income markets, and with the rates where they are, the earnings yield for stocks is still positive,” said Anu Gaggar, senior global investment analyst for Commonwealth Financial Network. “And now with the Fed keeping rates at these low levels, that just gives comfort to the market,” he added.

Watch the New Money video feature on Warren Buffett: How Most People Should Invest in 2021:

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Do you agree with the Buffett Indicator that US stocks are currently overvalued and headed for a crash? Or, do you think a different situation applies at present, and a crash isn’t imminent. Let us know what you think. Share your thoughts on the Buffett Indicator and the market in general by commenting below.

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