The ‘Buffett Indicator’ is going nuts

Once upon a time, investors believed that the value of the US stock market was tethered in some fundamental way to the overall productive capacity of the US economy, and the publicly traded companies whose profits depended on American growth.

One of those investors was — and at age 93, still is — Warren Buffett, Chairman and CEO of insurance, investment, and industrial conglomerate Berkshire Hathaway.

That’s just his day job, however. Buffett has long played an unofficial role as American capitalism’s affable, avuncular avatar, with the press and the public seeking out his folksy common sense both when the markets are gripped by speculative fever and when there’s an all-out crisis.

Buffett’s steadying influence flows, in a sense, from his association with value investing, the school of thought we alluded to before, that focuses on the prospect of a company’s earning power and prospective dividends, and ultimately the US economy, as the basis of investment decisions.

Typically, such value investors tend to be somewhat contrarian by nature. In frothy markets, they typically warn investors that that stock prices may be overvalued, and outpacing the ability of companies to produce profits and return money to shareholders. Conversely, when the markets tumble, they tend to see bargains, arguing the investors are too pessimistic about the stability of the US economy and how much money companies stand to make in the future. As Buffett said, “Be fearful when others are greedy, and greedy when others are fearful.”

One of the tools the Oracle of Omaha famously said he looks to in order to tell where we are in such a cycle is the ratio of stock market capitalization — that the total value on paper of the stocks that are publicly traded — as a share of gross domestic product, the most comprehensive gauge of the economy. It’s become known as the “Buffett Indicator.” Here’s a version of it.

Buffett laid out his thinking about this stat in a speech, that was published in Fortune magazine back in late 2001, as the market deflated from the tech stock boom.

The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.

Buffett’s well-known avoidance of the tech stock boom-and-bust of the 1990s, was perhaps one of the best calls in an investing career replete with them.

Today — thanks to the technological promise of AI, as well as the hype cycle surrounding it — we’re in another tech boom. And again, at least according to the Buffett Indicator, stocks are pretty clearly overvalued.

That’s not a reason to sell, of course. Globalization has deepened profit-making opportunities for the largest companies so the US economy may no longer be the best denominator. Buffett popularized this metric before China was even a member of the World Trade Organization.

And the market can stay overvalued for a long time, and delivering giant returns to investors as it does. Still, amid all the AI-related excitement, this common sense statistic seems worth keeping an eye on.