Buffett Indicator Hits All-Time High: Should You Be Worried?

The Buffett Indicator in Danger Zone

The Buffett Indicator, a stock market valuation gauge once favored by Warren Buffett, has climbed to an all-time high, reigniting fears that investors are once again pushing the market to unsustainable levels. The gauge compares the total market capitalization of publicly traded U.S. stocks (the Wilshire 5000 Index) to the country's Gross National Product (GNP).

What is the Buffett Indicator?

In a 2001 Fortune magazine commentary, Buffett described the indicator as "probably the best single measure of where valuations stand at any given moment." Others, including famed investor Paul Tudor Jones, have also cited it. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work out very well for you," Buffett said in a 2001 speech. "If the ratio approaches 200% -- as it did in 1999 and a portion of 2000 -- you are playing with fire."

New Record Levels

The indicator currently stands at a staggering 217%, well above the peak of the dot-com bubble and higher than the 190%+ it reached during the pandemic-era rebound in 2021. By this yardstick, today's stock market is in uncharted territory, as equity valuations are expanding at a much faster pace than the overall U.S. economic growth.

Big Tech's Dominance

The market rally has been fueled by big technology companies, which have poured billions of dollars into artificial intelligence development and have been rewarded with rich earnings multiples for the promise of this new era. Other valuation metrics are also flashing similar signals. The S&P 500's price-to-sales ratio recently climbed to 3.33, a new record, according to Bespoke Investment Group. For comparison, the dot-com bubble peaked at 2.27, and the post-Covid boom topped out at 3.21 before valuations cooled.

Is the Buffett Indicator Still Relevant?

Still, some argue that the Buffett Indicator may no longer be as relevant as it once was. Over the past two decades, the U.S. economy has changed dramatically, no longer being driven by so-called "asset-intensive" drivers as before, but increasingly by technology, software, and intellectual property. GDP and GNP may undervalue an economy built on data networks and innovation rather than physical factories. Therefore, higher stock valuations may be justified for an economy that is still the most productive and innovative in the world.

Buffett Building a "Cash Fortress"

Buffett has not commented on the indicator in years. But over the past two years, as he prepares to hand the CEO baton to Greg Abel, he has been building a "cash fortress" at Berkshire Hathaway. Second-quarter earnings showed a massive $344.1 billion cash hoard, and the group has been a net seller of stocks for 11 straight quarters.

Buffett's Cash Pile: A Warning Sign?

Even if the indicator is outdated, the fact that it is at such an extreme level coupled with the current positioning of the “Oracle of Omaha” is certainly noteworthy. The sheer size of Buffett's cash reserves, coupled with his ongoing selling of stocks, could signal a bearish outlook on future market performance. While this does not constitute investment advice, investors should consider it and assess their risk tolerance.