It is very difficult to time the market. Even when certain metrics are historically high or low, guessing exactly what the market will do next is typically a losing game. But that doesn't mean you shouldn't pay attention to these metrics. They can help you understand the greater picture.
Warren Buffett, for example, is holding a record amount of cash at his holding company, Berkshire Hathaway (BRK.A 0.16%)(BRK.B 0.10%). What makes Buffett seem so cautious? The valuation metric below holds some answers.
NYSE: BRK.A
Key Data Points
This stock market indicator should be a warning to all investors
Buffett has long advised investors against market timing. After all, over long periods of time, stock markets tend to rise in value. If you're jumping in and out of the market, that means your money has less time invested. And because most of the time markets go up, less time invested results in lower overall returns.
But this doesn't mean that Buffett is immune to fluctuating markets. When valuations are low, Buffett has more opportunity to put cash to work. But when valuations are high, Buffett understandably has fewer deals to chase, leading to a higher-than-normal cash balance at his holding company, Berkshire Hathaway.
How can we gauge the valuation of stock markets in general? By looking at the price-to-earnings ratio of a major index like the S&P 500. Right now, the S&P 500 trades at around 31.2 times earnings. The long-term average for the index is closer to 15 or 16 times earnings. So, according to history, the stock market is significantly overvalued today. But this simple take doesn't incorporate many important factors such as rising profit margins. As a recent report from T. Rowe Price concluded, market valuations "are elevated overall, but they appear sustainable given accelerating earnings growth and a return on equity near all-time highs."
Still, the fact that Buffett's company now has a record $344 billion in cash on the sidelines -- roughly one-third of its entire market cap -- generates caution about today's market valuation. And looking at the market's valuation overall, there has been a noticeable five-year pattern recently that should make investors wary of overextending themselves.
Image source: The Motley Fool.
Thanks to the rapid rise of the internet and related technologies in the last 30 years, the price-to-earnings ratio of the broad-based index has frequently traded at multiyear highs over this period, just like now. However, roughly five years ago, this valuation gauge also peaked at around 36 times earnings. Five years before that, in late 2015, this metric also reached a temporary high, just like it did in 2009, a bit more than five years prior.
To be clear, timing the market around this apparent pattern likely wouldn't have proven very successful. Price fluctuations can cause volatility, but so can earnings changes. A sharp drop could be due to rising earnings, not falling prices, and vice versa. So a big move may be in store for 2026, but the move could either be bearish or bullish. Combining this information, however, with Buffett's seeming inability to put his growing cash hoard to work should make you wonder: Are markets too expensive right now?
That may be the case. But long-term investors shouldn't be too concerned. Even if you had invested at the very top of market peaks over the decades, you still would have generated a profit had you held tight through today. But if you're close to retirement, getting a bit more defensive could be a wise decision. That's especially true if you already have enough to retire, but a sizable drop in net worth would get you in trouble.
Market timing is tough. The best approach is to emulate Buffett: invest cash when opportunities arise, and save it when they are scarce. This way, you'll naturally get more conservative when markets are expensive without intentionally doing so. And when valuations improve, you'll have excess cash to put to work.
