Warren Buffett's Favorite Market Indicator Shows the Stock Market Is Overvalued

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 (SNPINDEX: ^GSPC  ) are trading just below their all-time highs, and investors are wondering if this is still a good time to buy. Well, by many measures, including a market indicator that Warren Buffett uses, the market is overvalued. Let's see why.

The market today
So is the market overheating? Consider:

  • The average first-day pop of an IPO is 18%, the highest level in 10 years, even if the newly public companies are unprofitable and being valued on fuzzy metrics. Coupons.com is a good example: It's never posted a profit, yet it enjoyed an 85% first-day run-up and sports a price-to-sales ratio of 9.
  • Corporate profit margins are at all time highs, but earnings aren't growing. The S&P 500 is rising on multiple expansions in earnings and looks overvalued.
  • Individual investors' asset allocations to stocks are near their highest levels since September 2007, at 66.9%, according to the American Association of Individual Investors. 
  • Investors are using leverage at levels not seen since the last bubble to juice their returns, with margin debt as a percentage of the economy at a dangerous high.
  • The cyclically adjusted P/E ratio (the Shiller P/E) is at 25.8, 56% above its historical average of 16.5.
  • Respected investors including Jeremy Grantham, Wally Weitz, Donald Yacktman, Steven Romick, and Seth Klarman are building large cash positions.
  • The U.S. economy is growing slowly on the back of the Federal Reserve, which is pumping $65 billion a month into the market and now has a balance sheet of $4.2 trillion. Meanwhil,e the world economy is growing slowly on the back of China, which looks like it's in the late stages of a credit bubble.

So is the market is undervalued, fairly valued, or overvalued? Or are we in a bubble? I've written before of why I think the stock market is overvalued, but let's now turn to Warren Buffett.

Buffett's favorite market metric
In interviews with Fortune in 1999 and 2001, Buffett said that determining whether the market is expensive or cheap doesn't have to be complicated at all. His metric:

The market value of all publicly traded securities as a percentage of the country's business -- that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

Basically, Buffett divides the total market capitalization of the U.S. stock market by gross national product, or GNP. Not to be confused with gross domestic product, GNP measures the value of goods and services that a country's citizens produced regardless of where they live -- including what American companies produce abroad.

So when does the metric tell whether the stock market is expensive? Buffett again:

If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire.

Where is the stock market trading today?
At the end of February, the total market capitalization of U.S. markets, as reported monthly by the World Federation of Exchanges, was $24.6 trillion. The S&P 500 has risen 0.5% since then.

The Federal Reserve Bank of St. Louis, meanwhile, includes most U.S. economic data, though we won't get a report on GNP until the second revision of GDP on March 27. The most recent GDP data we have, for Q4 2013, is $17,080 billion. GNP has averaged $250 billion more than GDP for the past four quarters, so we shall assume Q4 2013 GNP is $17,107 billion.

Dividing the total market capitalization by GNP gives us a percentage of 142%, which, according to Buffett, indicates that the market is overvalued.

Foolish bottom bine
While I believe the stock market is overvalued, opinions differ. But with the Federal Reserve committed to low interest rates and pumping money into the economy, who knows how high the market can go? One thing is fore sure: It's getting harder and harder to find great companies at good prices. 

Stocks for the long haul
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Read/Post Comments (9) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 13, 2014, at 8:01 AM, jrainspe wrote:

    Historically, there is not one period where over valuation, in and of itself, caused a market crash or bear market.

    Over valuation does exacerbate the extent of a correction in either of those situations. After all, the higher you are, that farther you have to fall. Also, people panic in those kinds of situation and usually have a significant profit in the market that they try to protect at all costs.

  • Report this Comment On March 13, 2014, at 4:40 PM, Mathman6577 wrote:

    Anyone selling because of some arbitrary number is not likely to be a successful investor.

  • Report this Comment On March 13, 2014, at 8:00 PM, gskanwar wrote:

    Hi Thanks for the article. It is a great read. Are you able to provide the graph and the ratio on a quarterly basis and not only for the US but also for the UK and the Australian market. It is a very useful metric to have on a regular basis.

    Thanks again for the great articles and fool on.

    Gurkamal

    Melbourne Australia

  • Report this Comment On March 13, 2014, at 11:11 PM, daveandrae wrote:

    Not only do you trigger taxation and two sets of transactions costs when you decide to sell, for at some point you must get back in, but alternative investments (bonds and cash) are even more expensive than equities.

    In addition, Buffett himself has watched the value of his Berkshire stock decline 50% or more at least four times over his illustrious career. No matter how expensive he thought the market price was, he still didn't try to dance in and out of his position.

    Thus, this article, as most articles on this forum, is largely academic.

  • Report this Comment On March 13, 2014, at 11:52 PM, classic216 wrote:

    In November 2013, when the DOW hit 16,000, roughly where it is today, Warren Buffett said in a CBS interview; "We're still in the zone of reasonableness." He said stocks are "definitely not way overpriced."

    Strange how Buffett disagrees with what you claim is his own indicator. http://www.cbsnews.com/news/warren-buffett-talks-all-time-re...

  • Report this Comment On March 14, 2014, at 9:18 AM, TMFDanDzombak wrote:

    @classic216 Full quote was

    "I would say that they’re in a zone of reasonableness. Five years ago, I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced. Most of the time, they’re in an area where maybe they’re a little high, a little low, and nobody really knows exactly. They’re definitely not way overpriced. They’re definitely not underpriced."

  • Report this Comment On March 14, 2014, at 9:20 AM, TMFDanDzombak wrote:

    @gskanwar

    I think I can do that. I'll poke around this weekend

  • Report this Comment On March 27, 2014, at 12:26 PM, TMFDanDzombak wrote:

    I noticed an error

    "The most recent GDP data we have, for Q4 2013, is $17,080 billion. GNP has averaged $250 billion more than GDP for the past four quarters, so we shall assume Q4 2013 GNP is $17,107 billion."

    $17,080 + $250 is actually $17,330

    Double checking the spreadsheet I used $17,330 but did not change the number in the sentence.

    The first estimate of Q4 GNP was just released and came in at $17,373

    So DMC/GNP = 142%

  • Report this Comment On April 26, 2014, at 8:57 AM, yessireebob wrote:

    So forget the US market and head for Japan! Loads of Japanese stocks remain dirt cheap judging by valuation metrics like price to book, PERs, and dividends. Or just go to cash and stop buying.

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