Dow Jones Industrial Average (DJIA) futures collapsed in early trading Wednesday, pointing to a weak stock market open. And according to Warren Buffett’s favorite stock market indicator, this could be the start of a bigger downward trend.
The ‘Buffett indicator’ puts US stocks at their most overvalued level since the peak of the 2001 dot-com bubble. No wonder the Oracle of Omaha has been hoarding cash , perhaps anticipating a stock market correction.
The chart plots the total market capitalization of all publicly traded US stocks against GDP. Buffett famously called this indicator:
“The single best measure of where valuations stand at any given moment.”
The indicator currently reads 139%, higher than the peak of the dot-com bubble. A reading of 100% is considered dangerous. A reading of 140% is considered “extreme danger.” Investopedia advises that a safe level to enter the market is 70-80% .
Why is this indicator better than the typical price/earnings (P/E) ratio for pinpointing an over-priced Dow Jones? According to Global Macro Monitor, P/E can be easily manipulated by stock buy-backs and accounting tricks. The Buffett indicator is a stronger long-term, macro predictor.
Although the ratio is hovering at extreme danger levels, the Buffett indicator isn’t a reliable short-term trading tool. It offers a much broader, macro overview of market conditions.
“While this indicator is a general gauge of market valuation, it’s not useful for short-term market timing” – Advisor Perspectives .
Indeed, the gauge has been at dot-com bubble heights for over two years. In other words, it’s not an immediate trigger and the Dow Jones could pump higher before a correction materializes.
Much has been written about Warren Buffett’s record $122 billion cash pile at Berkshire Hathaway. Analysts, including our own at CCN.com, have suggested that Buffett is taking a defensive position in anticipation of a market correction.
If he’s right, and the stock market reverses, Buffett will have $122 billion on hand to buy up discount equities. This tactic has riled some investors though, including billion-dollar money manager David Rolfe at Wedgewood Partners. Rolfe pulled his $10 million stake in Berkshire Hathaway and accused Buffett of thumb-sucking.
“Thumb-sucking has not cut the Heinz mustard during the Great Bull Market. The Great Bull could have been one helluva an astounding career denouement for Messrs. Buffett and Munger.”
If the Buffett indicator is right, however, the Oracle of Omaha will be richly vindicated for staying on the sidelines.