How to Follow Buffett in Today's Market

Fear. There simply isn't enough of it to go around these days. The VIX -- Wall Street's "fear gauge" -- closed at 17.02 yesterday. It reflects investors' expectations for future stock market volatility, and prior to January, we hadn't seen the index that low since May 2008 -- the pre-Lehman bankruptcy era.

Why should investors care about this seemingly arcane number? As Warren Buffett wrote in an October 2008 New York Times op-ed column: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."

Applying Buffett's rule
In that opinion piece, Buffett exhorted investors to buy on the rationale that "fear is now widespread."

What a difference a year and a half makes! With much of the fear out of the market, investors' temperament now appears tipped toward greed. The VIX isn't the only indicator of this -- any decent market observer should be tripping over the signs -- and it's by no means a U.S.-centric phenomenon, either. Buffett's rule now suggests that, rather than buying heavily, prudent investors should favor caution.

But not all parts of the market point to investor complacency. According to data compiled by U.K. bank Barclays and Bloomberg, at the beginning of December, the difference in price between one-month and one-year options on the S&P 500 was higher than at any time since 1999, highlighting investor concern that analyst estimates of record earnings by 2011 are overoptimistic.

The earnings risk hanging over the U.S. market
Analysts are calling for a 20% increase in S&P 500 earnings in each of the next two years -- the highest rate since 1994.

The scope of this enthusiasm becomes apparent at the company level. Just look at the following companies, which have seen their earnings estimates surge over the past 12 months:

Source: Capital IQ, a division of Standard & Poor's.

This certainly appears inconsistent with an economy in which consumer credit remains tight and unemployment elevated. In testimony before Congress on March 25, Fed chief Ben Bernanke -- hardly an inveterate bear -- said, "The economy continues to require the support of accommodative monetary policies."

In fact, although the forward P/E of the S&P 500 looks quite reasonable at 15.0, a more reliable multiple tells a different story altogether. According to data compiled by Professor Robert Shiller of Yale, the S&P 500 is trading at a cyclically adjusted price-to-earnings (CAPE) multiple of 21.7, 33% above its long-term historical average. (The CAPE compares price to the average inflation-adjusted earnings over the prior 10-year period.)

In other words, the U.S. market is overvalued.

Two strategies in an overpriced market
That reality leaves investors with two alternatives:

• If you are mainly an index investor (i.e., your exposure to U.S. stocks is through index mutual funds or ETFs), you should be underweight the broad U.S. market.
• If you prefer to invest in individual stocks, it is acceptable for your portfolio to carry a normal weighting in equities if the names in your portfolio are no more than fairly valued. (It's preferable that they carry a margin of safety).

In short, valuation is key, because it drives returns over the long term.

Stockpickers: Valuations are vital
If you're not following one of these two strategies -- both valuation-driven -- you may now risk unacceptable (and unnecessary) capital losses.

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This article was first published on Dec. 11, 2009. It has been updated.

Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Atheros Communications and Chipotle Mexican Grill are Motley Fool Hidden Gems picks. Chipotle Mexican Grill is also a Rule Breakers pick. Bed Bath & Beyond is a Stock Advisorselection. The Fool owns shares of Atheros Communications and Chipotle Mexican Grill. The Motley Fool has a disclosure policy.