Even after Warren Buffett steps down as CEO of Berkshire Hathaway (BRK.A 0.52%) (BRK.B 0.62%), his legacy will live on. So will an indicator that bears his name.
Buffett told Fortune magazine in 2001 that this metric, now known as the Buffett indicator, is "probably the best single measure of where valuations stand at any given moment." And now the Buffett indicator is at the highest level ever, sending a warning.
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What is the Buffett indicator?
The Buffett indicator is the ratio of the total market cap of all U.S. stocks to U.S. gross domestic product (GDP). When Buffett first talked about this ratio in 1999, he used gross national product (GNP), which measures the total value of goods and services produced by a country's residents both inside and outside the country. GDP is more widely used than GNP as a measure of the U.S. economy and has replaced GNP in calculating the Buffett indicator.
In a sense, the Buffett indicator is similar to the most widely used stock valuation metric -- the price-to-earnings ratio. Instead of the share price of a single stock, the total market cap of all U.S. stocks is used. Instead of the earnings generated by a single company, the metric uses the total value generated by everyone in the U.S.
With the Buffett indicator and the price-to-earnings ratio, a lower number reflects a more attractive valuation. Buffett hinted at an ideal range for his namesake metric in the 2001 Fortune article, saying, "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."
History lessons
As you might have guessed, the Buffett indicator isn't anywhere close to the 70% to 80% range right now. It's slightly over 208% -- the highest level the indicator has ever reached.
If you want to know why Buffett isn't buying many stocks these days, the Buffett indicator probably explains it. He noted in 2001, "If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire." Today, the indicator isn't just approaching 200%; it has risen above that dangerous threshold.
Buffett's concern about a high market valuation as measured by the Buffett indicator has been justified by history. He mentioned the indicator spiking in 1999 and 2000, reaching what was then an all-time high. Many investors remember what happened soon afterward. The dot-com bubble burst, with the S&P 500 (^GSPC 0.27%) plunging nearly 50% below its previous peak by late 2002.
The Buffett indicator again came close to hitting 200% in November 2021. Within a matter of weeks, the S&P 500 began to sink and eventually fell as much as 25%.
Will the stock market crash again soon?
These historical precedents aren't encouraging for investors. However, the Buffett indicator isn't great at predicting short-term stock market moves. For example, the indicator has been above its level in early 2000 (right before the dot-com bubble burst) for most of the period since 2018. During this time, the S&P 500 has soared more than 130%, albeit with significant volatility.
However, there's no getting around the fact that U.S. stocks are historically expensive. The Buffett indicator isn't the only metric that reflects this. The S&P 500 Shiller CAPE ratio, popularized by Yale economics professor Robert Shiller, is near its third-highest level ever.
S&P 500 Shiller CAPE Ratio data by YCharts
Stock valuations don't tend to remain above historic levels for too long. Sooner or later, they will return to a more normal range. With the Buffett indicator at an all-time high, investors probably should brace themselves for what the stock market might do over the near term and almost certainly will do eventually -- revert to the mean.
