The stock market has been running red hot in the past few weeks as investors bet on the resurgence of AI, interest rate cuts, and a potential soft landing to the economy, averting the much-feared recession.
As a result of this, Warren Buffett’s favourite market gauge is flashing red, signalling that US stocks are overvalued relative to their historical valuation in the market.
As of 31 Jul 2023, the Buffett indicator ratio hits 182% at an approximate +1.7 standard deviation above the historical mean.
In a Fortune article back in 2001, Buffett once said that stocks would be fairly valued at a 100% reading, and if investors are buying at roughly 70% to 80% level, it will be an absolute steal entry price that would work out nicely in the long term. Buffett, however, warned that investors would be buying at an overvalued market and “playing with fire” when the indicator is near the 200% mark.
Much of the case in the last 10 years have been a period of ultra-low interest rates, and because of this you could understand why stock markets tend to be overvalued as it represented the best asset returns.
After all, Buffett’s indicator tracks the total market capitalization of all actively traded US stocks, and divides that by the latest estimate for quarterly GDP. Essentially, if the ratio remains higher than 100%, it simply means that the stock market is running ahead of the GDP and a space too crowded is not always a good thing.
To date, the Wilshire 5000 Total Market Index has jumped 22% this year, lifting its market capitalization to $46.3 trillion as of 31 Jul 2023 close. Its gains have been fuelled by a 19% rise year to date in the S&P 500 and 37% surge in Nasdaq Composite.
Whether or not Buffett indicator is a flashing warning remains to be seen as investors continue betting on the bullishness return of the economy, fuelled by strong jobs report as well as inflation decline, which will encourage rate cuts sooner than expected.