Buffett Indicator Sounds the Alarm on Stocks

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Since taking the helm at Berkshire Hathaway in 1965, Warren Buffett has compounded capital at about 20% per year.

That’s almost double the annual return of the S&P 500, which over 6 decades equates to a shocking 120x total outperformance. This is the incredible power of compounding.

Buffett built his fortune the old-fashioned way. He bought quality companies on the cheap and sold them for substantial long-term gains. At times, he risked a large percentage of his capital on concentrated bets when he had high conviction.

Buffett Indicator Indicates a Problem

As investors, one of our most important jobs is to judge when stocks become overvalued and it’s time to start taking profits.

Throughout his remarkable career, Warren Buffett built up an arsenal of tools he uses to maximize returns. This is the purpose of Warren’s favorite valuation metric, known as the Buffett Indicator. This is simply a ratio between the size of the American economy and the size of the stock market.

When the stock market becomes substantially larger than the underlying economy (as measured by GDP), Buffett noticed that this indicated stocks were becoming relatively expensive.

Here is a long-term chart of the Buffett Indicator (total U.S. market cap to GDP – a higher ratio indicates more expensive stocks):

Source: BuffettIndicator.net

As you can see, in 2000 during the first internet bubble, the indicator reached about 150%. This was a sign to Buffett that stocks were highly overvalued. As a result, Berkshire avoided the overvalued tech sector and significantly outperformed the market.

In the post-COVID era, the Buffett Indicator has soared to new all-time highs. We are currently around 190%. This indicates that the market sits at extreme price levels.

It’s hard for me to look at today’s valuations and see anything but a bubble. Even after the recent pullback, stocks are still priced for perfection.

Buffett Taking Profits, Hoarding Cash

Today, Warren Buffett’s firm is taking profits on long-term positions including Apple and Bank of America. Berkshire Hathaway has built up an unprecedented cash position of $334 billion. That’s about a third of the entire company’s value stashed away, mostly in short-term U.S. treasuries.

Buffett seems perfectly content collecting around 4% interest on his cash pile, and waiting for better buying opportunities down the road.

Judging by the Buffett Indicator, currently at 190%, Buffett may not be making substantial buys anytime soon. The market would have to crash by more than 50% to bring the indicator back into Buffett’s classic “buy zone”.

We’ll keep an eye on this and other important metrics over the weeks and months to come.

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