Please ensure Javascript is enabled for purposes of website accessibility

Are Stocks Overvalued? This Market Indicator Says So.

By Diane Mtetwa – Updated Aug 21, 2020 at 10:58AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

A popular market indicator suggests that investors should prepare for a possible market crash.

When the markets crashed earlier this year, you may have braced yourself for a bear market. With over 10 years of positive gains, a raging pandemic, and record unemployment numbers, plummeting stocks seemed to be a given. But much to everyone's surprise, the mid-March panic didn't last long. Skepticism about this quick V-shaped recovery probably has you wondering whether the market is overvalued, and whether a bubble is forming. Based on a favorite market indicator of superinvestor Warren Buffett, a pullback could be brewing -- and soon. 

How the indicator works

The stock market capitalization-to-GDP indicator, also known as the "Buffett indicator," looks at the value of the stock market relative to GDP. In a 2001 interview with Fortune, Buffett called this metric "probably the best single measure of where valuations stand at any given moment."

If this indicator trades under 100%, it suggests that the market's placing appropriate values on stocks. But when this indicator starts trading over 100%, you should start paying close attention.

Frustrated man looking at a tablet and seeing stocks decline in value.

Image Source: Getty Images

This famous market indicator was trading over 100% in both 2001 and 2008, prior to our two most recent crashes -- but it's not perfect . Before the late 1990s, this indicator only traded under 100%, which means that it didn't capture significant crashes like Black Friday in 1987. 

This market indicator has also been trading over 100% consistently over the last few years. Even when the markets pulled back in December 2018, this indicator stayed above 100%, which has financial professionals wondering whether the percentage needs to be revamped and pushed higher.

Low interest rates could explain the consistently high percentages. The 10-year treasury rate has traded below 5% since 2007, leaving investors with few options for their money more lucrative than stocks. This has made them more prone to stick out the stock market ups and downs -- driving market capitalization up . 

Additionally, today's low GDP very specifically relates to massive shutdowns because of COVID-19. If the United States returns to its former glory once shutdowns are reversed, GDP would increase, lowering the indicator. 

How to reallocate your portfolio

The evidence above suggests that this market indicator isn't as straightforward as it seems. It's best used in combination with other signals of stock market weakness, like a high price/earnings ratio. But despite these uncertainties, the Buffett indicator is still currently trading at an all-time high of 178% -- and the size of that disparity worries financial analysts most. If their concerns are valid, we could be headed for a long, drawn-out market crash. Should that come to pass, here's how you can prepare.

If you don't plan on using your money anytime soon, you can set up a portfolio that includes more dividend-paying value stocks, which tend to do better in bear markets because their cash flows help to offset losses. Not every value stock pays dividends, but more of them pay dividends compared to growth stocks. Moving money into industries that are better primed to do well during this pandemic, like healthcare or technology, is also a great defensive play. 

You should reevaluate your current asset allocation model if you'll need to access your invested money soon, or if you found the pullback in March emotionally draining, and you're looking to avoid another one. Selling some of your stocks and buying low or non-correlated assets, like bonds and commodities, will help you lower the amount of risk you're taking and avoid losses.  In 2008, investors who were invested 100% in large-cap stocks lost 37% of their portfolios, while investors who held 60% stock lost 22.4%. 

If economic conditions don't improve, the stock market capitalization-to-GDP indicator will trend even higher, potentially leading the stock market to reverse course -- instead of the V-shaped recovery, we'll end up with one that is W-shaped. There's not much that you can do to prevent this from happening, but taking these few steps can better prepare you to weather the storm. Just keep in mind that time in the market is more important than timing the market. A move to more conservative investments will result in lower annualized returns for your portfolio -- but it should be a long-term decision, instead of one for the time being. 

The Motley Fool has a disclosure policy.

Related Articles

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.