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Buffett's Favorite Metric Shows the Stock Market Today Is Expensive

By Dan Dzombak - Apr 5, 2013 at 5:15PM

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With the Dow and S&P 500 at all time highs, it pays to consider if the market is overpriced.

The stock market is down today after a terrible jobs report, but that doesn't mean it's cheap. By many measures, the stock market is still expensive, and I'm going to highlight one of the measures that Buffett uses to determine if the market is expensive or cheap. That metric shows the market is still expensive; read on to find out more.

Stock market today
Today, the Dow Jones Industrial Average (^DJI 1.76%) was down 41 points, or 0.28%, to 13,565. The S&P 500 (^GSPC 2.47%) was down 6.7 points, to 1,553.

The big news today was the jobs report, which showed the U.S. added just 88,000 jobs in March, down from 268,000 in February. Analysts were expecting jobs growth of 190,000, so a 102,000 job miss was huge. The U.S. recovery has been slow, but steady. Hopefully, this report was an aberration and not a sign of bad things to come. While the report was bad, the Dow was barely down this week, and still stands near a five-year high.

The telltale metric that  the stock market is currently expensive
In 2001, Buffett explained to Carol Loomis in Fortune magazine that determining whether the market is expensive or cheap doesn't have to be complicated at all. The metric Buffett uses is:

The market value of all publicly traded securities as a percentage of the country's business -- that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.

Basically, Buffett divides the total market capitalization of the U.S. stock market by gross national product, or GNP. For a refresher, GNP measures the value of goods and services that a country's citizens produced regardless of where they live. This includes the value of goods and services that American companies produce abroad.

So how do you tell if the stock market is expensive? Buffett went on to explain that: "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire."

Where is the stock market trading today?
With the Dow basically unchanged from where it started the month, we can easily use the most recent data, which is for March 29th. The most common way to calculate the market value of all publicly traded securities is by looking up the market capitalization of the Wilshire 5000, which tracks the largest 5000 companies in the U.S. with "readily available price data." At the end of March, the market cap of the Wilshire 5000 was $19.0 trillion.

To find GNP, the Federal Reserve Bank of St. Louis has a great website where you can find most U.S. economic data. The most recent data for GNP is Q4 2012, when GNP was $16.1 trillion.

Dividing the total market capitalization by GNP gives us a percentage of 118%, which indicates the market is expensive.

Foolish Bottom Line
With the Federal Reserve committed to low interest rates and pumping money into the economy through QE3, who knows how high the market can go. Investors who are putting new money to work now will likely see low returns going forward. It's getting harder and harder to find great companies at good prices.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
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S&P 500 Index - Price Return (USD)
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