The bulls are ready to run. So far this year, the Nasdaq Composite Index has soared more than 30%. The S&P 500 isn't far away from a 20% gain.
But investors shouldn't celebrate too much just yet. Here are three reasons the stock market could sink in the second half of 2023 -- and what Warren Buffett is doing.
Image source: Getty Images.
1. Sky-high valuation
A sky-high valuation arguably ranks as the biggest reason to worry that the stock market is perhaps getting ahead of itself. Stocks are expensive on an overall basis from nearly every angle.
For example, the forward price-to-earnings ratio for the S&P 500 currently tops 19x. Sure, the multiple was higher during the boom period in the second half of 2020 and throughout 2021. Before then, though, we have to go all the way back to the aftermath of the dot-com bubble in the early 2000s to find the S&P priced at so much of a premium.
Then there's the "Buffett indicator." This indicator divides the stock market's total market cap by the nation's gross domestic product (GDP).
It got its nickname because years ago Buffett praised it as "probably the best single measure of where valuations stand at any given moment." The higher the Buffett indicator is, the more overvalued stocks are. And when the stock market's valuation becomes too frothy, a correction is usually on the way.
US Total Market Capitalization as % of GDP data by YCharts
Granted, the Buffett indicator has pulled back somewhat. However, it's beginning to rebound. More importantly, the metric is near the highest level it's ever been.
2. Recession forecasts
I know, many so-called experts have been predicting a recession for a while now. So far, though, the U.S. economy has continued to chug along pretty well.
Three months ago, the Federal Reserve's economists warned that a U.S. recession could be likely in late 2023. The good news is that the Fed is now sounding more upbeat that a recession could be avoided.
Don't rule out the possibility, however, that a recession could materialize later this year. A recent Bloomberg survey found that 63% of economists still expect an economic downturn within the next 12 months. The stock market often begins to decline even before the economy does.
3. Money supply
Many investors don't think much about money supply. But maybe they should.
Money supply is basically what its name says: the total amount of money in supply or circulation within a country. The two main money supply metrics are M1 and M2. M1 includes all physical currency in circulation, while M2 adds deposits in savings and money market accounts.
Going back to 1870, every single time M2 money supply has fallen by 2% or more, a major U.S. economic downturn has followed. In three cases, depressions occurred (including the Great Depression).
US M2 Money Supply data by YCharts
As of right now, M2 money supply has declined by more than 4%. If history is any guide, a recession could be on the way regardless of what the experts are predicting. That's potentially bad news for the stock market.
What's Buffett doing?
Buffett almost certainly isn't trying to time the market. He wrote to Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) shareholders earlier this year that he and his longtime business partner Charlie Munger "firmly believe that near-term economic and market forecasts are worse than useless."
However, Buffett is nonetheless an astute observer of economic and market conditions. He knows that stock valuations are high. He understands the factors impacting the U.S. economy. So what is he doing now?
First, he's built up a big cash stockpile for Berkshire. Most of that cash is being held in short-term U.S. Treasurys, which currently offer relatively attractive yields.
Second, he's continuing to invest for the long term. For example, Buffett recently added to Berkshire's stakes in Occidental Petroleum and five Japanese trading houses. The common denominators for these stocks is that their valuations are attractive and they have solid prospects.
These two steps could be prudent moves for investors who aren't multibillionaires, too. Focusing on valuation and business prospects is especially a great idea -- even if the stock market doesn't sink later this year.
