Warren Buffett doesn't believe in paying too much for a stock. He studied under Ben Graham, who's often referred to as the father of value investing.
The legendary investor has called one indicator the best valuation metric of all. Here's what it is -- and what it's saying about the stock market now.
Image source: The Motley Fool.
The "Buffett indicator"
Back in 2001, Buffett told Fortune magazine that one gauge was "probably the best single measure of where valuations stand at any given moment." That metric divides the total market cap of the stock market by the gross domestic product (GDP). The high praise that he gave to the metric led to it being widely referred to as the "Buffett indicator."
The Fortune interview came on the heels of the bursting of the dot-com bubble. Buffett said at the time that the U.S. version of the indicator should have provided a "very strong warning signal" of a looming sell-off.
Indeed, the Buffett indicator skyrocketed to more than 140% in 2000. Later that year, the S&P 500 began to sink.
The lower the Buffett indicator is, the more attractively valued the stock market is -- and vice versa. Buffett said in the Fortune interview nearly 22 years ago that buying stocks when the metric is around 70% or 80% can pay off. He added, though, that buying stocks when the indicator gets close to 200% is like "playing with fire."
What it's signaling now
So what does the Buffett indicator say about the stock market today? Well, investors aren't all that far away from playing with fire.
US Total Market Capitalization as % of GDP data by YCharts
The Buffett indicator currently tops 150%. That's even higher than it stood before the dot-com bubble burst or the market crash that began in 2008.
Of course, the metric was even higher in late 2021 and early 2022. The S&P 500 promptly proceeded to plunge 19.4%.
It isn't just U.S. stocks that are priced at a premium. The global version of the Buffett indicator, which measures the total market cap of stocks across the world versus the worldwide GDP, is close to 110%.
What should investors do?
Just because the Buffett indicator is elevated doesn't necessarily mean that a stock market downturn is imminent. After the COVID-19 sell-off in early 2020, stocks went on a tear throughout the rest of the year and into 2021, even with the Buffett indicator at high levels.
However, valuation matters. When there are signs that stock prices are becoming overly frothy, investors would be wise to exercise caution.
One prudent step is to follow in Buffett's footsteps by building a cash reserve. This gives you money to deploy when stocks are available at more attractive prices.
Another alternative is to invest in assets other than stocks. For example, bonds could be more appealing now, with the likelihood that the Federal Reserve won't raise interest rates too much more.
Investors don't have to completely avoid stocks altogether, though. Buffett isn't. He initiated three new positions for Berkshire Hathaway in the first quarter of 2023 and added shares to seven other existing positions. Buffett also scooped up more shares of five Japanese stocks earlier this month.
But you can rest assured that the legendary investor paid very close attention to the valuations of all the stocks he bought. As mentioned, Buffett doesn't believe in paying too much. And the indicator that bears his name appears to show that many stocks are priced too high right now.
