The Buffett indicator is issuing a warning to investors.
A hedge fund founder believes that the information provided by this indicator is very clear, that is, the US stock market looks very expensive. Buffett's indicator is to "divide the total market value of all actively traded US stocks by the estimated value of the latest quarter's GDP." As early as 2001, Buffett said that this "might be the best single measure of where valuations stand at any given moment".
In early July, this ratio rose above 2 to a level not seen since the beginning of 2022. According to FactSet data, the last time this ratio rose, it heralded the worst annual decline of the S&P 500 index since 2008.
Doug Kass, founder of hedge fund Seabreeze Partners Management, said, "Nearly two years ago, this ratio rose to unprecedented levels. This should be a very strong warning signal."
It is worth noting that Buffett himself no longer relies on this indicator, but investors like Kass still use it to help determine whether stocks are cheap or expensive.
This indicator has been quite reliable and reasonable in the past. Previously, it indicated the situation where stocks were extremely overvalued relative to US economic output, and it respectively predicted significant sell-offs in 1987 and 2000, as well as on the eve of the financial crisis.
Overall, Kass said that when this indicator reaches two standard deviations above its long-term average, investors should start paying attention. Today, it is at this level.
Currently, Buffett's indicator is not the only signal indicating that stock valuations are too high. Kass said that other popular valuation indicators, including the P/E ratio, P/S ratio, and enterprise value-to-sales ratio over the past 12 months, are all above the 90th percentile relative to history.
Like other indicators, Buffett's indicator also has its flaws. One issue is that it does not take interest rates into account, and currently interest rates are at their highest level in over 20 years. Kass also noted that it has not taken into account the fact that the share of foreign corporate profits has been increasing. "Investment portfolios are very complex, and no single indicator is ironclad."
Another unique potential problem today is that most of the market's gains over the past 18 months have been driven by a few large-cap stocks. This means that the indicator may overlook the fact that many stocks are still relatively cheap compared to history, while a few stocks are extremely expensive.
According to FactSet data, the S&P 500 index reached its 36th record closing high of the year on Tuesday. The Nasdaq Composite Index also hit a new high, while the Dow Jones Industrial Average fell again and remains in a downward trend.