A bull market is coming. No, wait -- the stock market is about to crash. Actually, stocks will muddle along in 2023. You can find market pundits predicting any of these contradictory scenarios.
Warren Buffett wrote to Berkshire Hathaway shareholders earlier this year that near-term market forecasts are "worse than useless." However, there's an indicator that bears his name that some investors believe could provide a clue to what might be in store.
What's next for the stock market? Here's what the Buffett indicator reveals.
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About the Buffett indicator
Buffett wrote in Fortune magazine in 2001 that the ratio of the total U.S. stock market value divided by gross domestic product (GDP) was "the best single measure of where valuations stand at any given moment." This ratio soon became known as the Buffett indicator.
That article was written as the stock market was sinking as the dot-com bubble burst. Buffett argued that the extremely high ratio of total U.S. stock market capitalization to GDP "should have been a very strong warning signal" that a downturn was on the way.
So where does the Buffett indicator stand now? As of March 29, 2023, the total U.S. stock market capitalization was around $42.5 trillion. U.S. GDP was $26.13 trillion at the end of 2022. But the Federal Reserve Bank of Atlanta provides a more up-to-date estimate of the current quarterly GDP growth rate online. Using the latest estimate, the U.S. GDP currently is close to $26.35 trillion. Dividing the $42.5 trillion total U.S. stock market valuation by the GDP of $26.35 gives us a Buffett indicator level of 161%.
What it could mean for stocks
Buffett wrote in 2001 that when the ratio of total stock market capitalization to GDP falls to around 70% to 80%, buying stocks is likely a smart move. But he noted that when the ratio gets close to 200%, buying stocks is like "playing with fire."
The Buffett indicator is closer to the danger zone than it is to the buy zone right now, at least based on Buffett's views from years ago. Despite declining quite a bit this year, the ratio remains higher than it's been throughout most of the last 50 years.
However, the Buffett indicator has trended higher over time. Some speculate that U.S. GDP isn't reflecting all of the profits made by big U.S. companies in international markets and think a higher level is justified. Even if this view is correct, though, the current level of the Buffett indicator is above its trend line going back to early 2009.
Some investors might argue that the Buffett indicator isn't too much higher than its trend line, potentially indicating that the stock market is fairly valued. Based on this perspective, it's possible that stocks could rise modestly. But the Buffett indicator doesn't appear to be pointing to a strong new bull market.
Drawbacks
There are other indicators that seem to be signaling a new bull market is on the way soon. Others could mean that stocks will fall. Which indicator should investors use to make decisions? Perhaps the best answer is "none of the above."
Every indicator has its drawbacks. Arguably the main one for the Buffett indicator is that it isn't very good at predicting short-term market moves.
Instead of buying or selling stocks based on the Buffett indicator, a better strategy for investors would be to follow the advice of the indicator's namesake. Evaluate the future earnings potential for any stock you're considering. Only buy the stock if the valuation is attractive relative to its future earnings. And most importantly, always focus on the long term.
