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The Key Takeaways
- A stock market indicator once favored by legendary investor Warren Buffett is hovering around levels that Buffett has previously compared to "playing with fire."
- The "Buffett Indicator" compares the total value of the U.S. stock market to GDP to determine the market's worth relative to the economy.
- Buffett's Berkshire Hathaway was a net seller of stocks in the most recent quarter, when the conglomerate's cash pile grew to a record $320 billion.
If you use a measure of valuation once preferred by Warren Buffett, the most famous investor in history, then this could be causing concern.
America’s market capitalization-to-GDP ratio, or so-called Buffett Indicator, is hovering around 200%, a level that Buffett compared to “playing with fire” A 2001 Fortune magazine article.
Calculations of the ratio are different due to difficulties in determining the total value of U.S. stocks. The figure was 208% for some at the end the third-quarter. Investopedia calculated it at slightly less than 200%, based on GDP data from Bureau of Economic Analysis (BEA) and SIFMA market capitalization figures.
The ratio has reached a point that Buffett described as concerning two decades ago. “Nearly two years ago the ratio rose to an unprecedented level,” In 2001, the author wrote a letter referring to dotcom bubble. “That should have been a very strong warning signal.”
The inflated value of the market is a potential explanation for why Buffett’s Berkshire Hathaway (BRK.A; BRK.B) has been selling stock in recent months and growing its cash pile.
What is the Buffett Index?
Buffett was referring in 2001 to the comparison between the total stock market value and the U.S. Gross National Product (GNP), which is a slightly different measure of economic activities than the widely used gross domestic product. Today, as has historically been the case, the difference between the two is small—just $15 billion, or 0.05% of GDP.
Buffett acknowledged that the ratio "has certain limitations." He still called it. “probably the best single measure of where valuations stand at any given moment.”
Buffett stated in 2001 that this was a likely entry level to the stock markets in 2010, 2011 and when the stocks recovered from the 2008 crash.
What does Buffett do with his stocks?
Berkshire Hathaway’s cash reserves have reached record highs by selling stock more than what it bought.
Buffett may be reluctant to invest more in a market that appears overvalued, but the firm’s $320 billion of cash and other equivalents could also be used as a basis for potential acquisitions. Buffett said Berkshire was open to these deals in previous years. The Wall Street Journal recently reported that Berkshire could buy the majority of U.S. companies, except for 25.
However, Bloomberg columnist Nir Kaissar wrote recently that based on Buffett's track record of favoring the long view, pulling cash out of the market is likely indicative of his belief that the long-term returns of the market are less than ideal, rather than a prediction of an imminent downturn.
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