Warren Buffett’s favorite market indicator says stocks are in trouble.
The billionaire chief executive of Berkshire Hathaway once wrote that the “single best” way to see if the market is too expensive by comparing the total value of all publicly traded stocks with the total size of the economy.
It’s like determining the value of a car by the horsepower of its engine.
If the value of all stocks is 80 percent or less than the size of the economy, then “buying stocks is likely to work very well for you,” Buffett wrote in Fortune magazine 16 years ago. When the market value is greater than the economy, it’s a sign of excessive investor optimism.
“Today, Buffett's favorite market indicator is flashing its biggest warning sign yet,” Paul J. Lim writes in Money magazine.
The Wilshire 5000 Total Market Full Cap Index, which actually only measures about 3,600 stocks, has a value of $26 trillion, which is 135 percent of U.S. gross domestic product.
“By this measure, stocks are frothier than they've ever been — even in the months leading up to the 2000 dot-com crash or the global financial panic that began in 2007,” Lim writes.
He cautions that today there are some differences from the measurements Buffett used in 2001. Buffett cited gross national product instead of GDP to gauge U.S. economic output.
GDP measures all economic activity in a country, even if that’s produced by foreign citizens or companies. GNP is focused on American output, including overseas activity.
U.S. GNP is greater than GDP because of the amount of production outside of U.S. borders. That means Buffett’s ratio isn’t at an all-time high, but it’s getting close.
The record for U.S. stock market capitalization to GNP was 136 percent in the first quarter of 2000, the height of the dot-com bubble that collapsed over a three-year period. Today, the figure is about 134 percent, higher than the long-term average of less than 74 percent.
Expensive valuations may be one reason Berkshire Hathaway has a record $100 billion in cash ready to put to work.
“The fact that he is willing to hold so much of his company's assets in cash is a testament to how few bargains he sees in this market,” Lim writes. “And that would confirm what Buffett's favorite market indicator is now signaling.”
Meanwhile, Buffett's optimism for the future of the United States hasn't diminished.
"Whenever I hear people talk pessimistically about this country, I think they're out of their mind," Buffett said Tuesday night at an event celebrating the 100th anniversary of Forbes magazine. He's on the cover of an issue showcasing 100 of the world's greatest living "business minds."
Buffett said he expects the Dow Jones Industrial Average to be "over 1 million" in 100 years, compared with Tuesday's close of 22,370.80. He said his forecast isn't too far-fetched, given how the index was roughly 81 a century ago.
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