'Buffett Indicator' Spells Bad News for Stock Investors

While many investors and market watchers typically use price-earnings (P/E) ratios, or some variation thereof, to gauge stock market valuations, master investor Warren Buffett focuses on a different barometer. He prefers to compare the market capitalization of all publicly-traded U.S. stocks to U.S. GDP, calling, this "the best single measure of where valuations stand at any given moment," as quoted by MarketWatch. Right now, this ratio is at an all-time record high of 138%, according to Adem Tumerkan of Palisade Research, who says, per MarketWatch, that this points to "extremely overvalued stocks" and "huge downside ahead." (For more, see also: Why the S&P 500 May Fall More than 60%: Hussman.)

'Buffett Indicator:' Red Flags Are Rising

(Total U.S. Market Value Relative to GDP)

Value Signal
70% to 80% Safe to put money in stocks
100% Danger
140% Extreme danger

Source: Palisade Research, as reported by MarketWatch.

The Buffett Indicator was at elevated levels before the dotcom crash of 2000 to 2002, and before the financial crisis of 2008, but at respective values of 137% and 105%, lower than today's reading, MarketWatch adds. Tumerkan compares the Wilshire 5000 Index to nominal quarterly GDP in his variation of the analysis. If that were not worrisome enough, seven other market indicators are flashing warning signals, according to longtime market observer Mark Hulbert, MarketWatch adds.

'Rolling Bear Market'

Morgan Stanley recently cautioned investors to brace for the worst market selloff since the correction in late January and early February, per another MarketWatch story. While disappointing earnings reports from Facebook Inc. (FB) and Netflix Inc. (NFLX) had limited negative impact on the broader market, a Morgan Stanley team led by chief U.S. equity strategist Michael Wilson, wrote, per MarketWatch, "We believe this simply led to an even greater false sense of security in the market."

Morgan Stanley sees, as quoted by MarketWatch, "a rolling bear market" in which "every sector in the S&P 500 has gone through a significant derating." The only exceptions so far, they note, are information technology and consumer discretionary, which are up by more than 15% and 13%, respectively, for the year-to-date (YTD) through August 3, per S&P Dow Jones Indices. Consumer discretionary, according to S&P's official classification, contains both Netflix and Amazon.com Inc. (AMZN), which are up by more than 80% and 50% YTD, respectively.

7 Other Bearish Indicators

In addition to the Buffett Indicator, Mark Hulbert finds that seven others also are pointing to excessive U.S. stock market valuations, as he writes in his Wall Street Journal column. Hulbert gained notoriety with his Hulbert Financial Digest, which rated investment newsletters on predictive accuracy. The best indicator based on history going back to 1954, he says, is one favored by an anonymous blog called Philosophical Economics. Looking at household financial assets, which include stocks, bonds and cash, it finds that the higher the proportion of stocks, the closer we are to a market top. Right now, per Hulbert, this indicator is at its most bearish since right before the 2008 financial crisis.

In second place, in order of predictive ability, is the Q Ratio, devised by the late James Tobin, a Nobel Laureate in Economics. It compares the market value of assets to their replacement cost. Third is the price-to-sales (P/S) ratio for the S&P 500 Index (SPX).The Buffett Indicator is in fourth place.

Rounding out the list are Nobel Laureate Robert Shiller's CAPE ratio, the S&P 500 dividend yield (the lower it is, the more expensive stocks are), the traditional P/E ratio for the S&P 500 based on the last 12 months of actual earnings, and the price-to-book value (P/B) ratio for the S&P 500. The CAPE ratio has drawn particular attention this year, after reaching a level higher than that before the Great Crash of 1929, though critics see shortcomings in this analytic tool. (For more, see also: Why The 1929 Stock Market Crash Could Happen in 2018.)

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