The Warren Buffett Indicator: Head for the Hills or Hold Steady?

Warren Buffett Indicator

They call him the Oracle of Omaha. And when he speculates about where the market’s headed, or what it’s about to do, people drop what they’re doing and pay attention. The most wildly successful investor of the last hundred years, Warren Buffett has amassed a fortune that most millionaires only dream about – and that the majority of humans will never see. At the age of 83 and boasting a net worth somewhere near 60 billion (that’s billion, with a “b”), Buffett is arguably at the peak of his stock prognostication game. And he’s warning fellow investors that the stock market is poised for what could be a major correction… or an all-out crash.

The Warren Buffett Indicator Explained

Buffett’s market prediction methodology – which is appropriately referred to as “The Warren Buffett Indicator” – is one that he himself has called “probably the best single measure of where valuations stand at any given moment.” In plain English, the indicator states that the best measure of whether a market is undervalued (good) or overvalued (bad) is determined by the relationship between total market capitalization and the GDP (gross domestic product). Also commonly referred to as the “Total-Market-Cap to GDP Ratio,” the indicator is expressed as a ratio. If total market capitalization is more than 100 percent of the gross domestic product, this means stock is highly overvalued. Thus, the Warren Buffett Indicator screams “SELL!”

Evidence of Past Accuracy

The Warren Buffett indicator isn’t exactly what anyone would call a far-fetched concept. In reality, it’s hard math. When market cap stands at more than 100 percent of the GDP, it essentially means that national economic output is lower than the amounts being earned by the companies fueling that economy. And although not a fool proof science – Buffett has admitted the ratio “has certain limitations in telling you what you need to know” – it’s logical to perceive it as indication the stock market is straying into the off-kilter zone. In 2000, just prior to the epic dotcom bubble pop that sent the market spiraling, the Total-Market-Cap to GDP Ratio was at 183 percent. Seven years later when the housing market nosedived and brought the economy down in a sickening plunge, the ratio was at 135 percent.

Investment Ebook

Where the Warren Buffett Indicator Stands Today

“Those who cannot remember the past are condemned to repeat it,” said the Italian philosopher George Santayana. Those words, written more than 100 years ago, hold truer today for the modern investor than at any time in the past. With that in mind, it’s time to heed that sage advice and cast the Buffett Oracle ahead, by simply looking at what’s happening today. According to recent data, today’s Total-Market-Cap to GDP Ratio stands at 142 percent – a full seven points higher than it was just prior to the housing bubble burst of 2007. Nervous yet? If not, you should be.

Parting Thoughts

Alas, it’s prudent to remember yet another old saying. You know it well. It’s the one that talks about gray clouds and silver linings. In this case, that proverbial silver lining could manifest itself in the opportunity for prospective investors awaiting the chance to buy stocks low. If the Warren Buffett Indicator holds true, investment holdouts could see their time coming. But this doesn’t mean those who have already poured their savings into the stock market should necessarily cash out and head for the hills. As is the case with the vast majority of investments of substantial size, the smartest thing to do could be to hold steady and ride out the big shift many others have agreed is about to occur. Whatever the decision, investors should make it based on diligent research and updated data.