Warren Buffett’s favorite market metric suggests investors are ‘playing with fire’

Published: Oct 31, 2017 1:35 p.m. ET

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‘If you stick your head in the sand and pretend that this isn’t anything to be concerned about, you aren’t going to like what comes next.’

Reuters

Warren Buffett participates in the newspaper tossing challenge.

Warren Buffett once described his favorite market indicator as “the best single measure of where valuations stand at any given moment” and that when the metric exceeds certain levels, like it did back in 2000, “you are playing with fire.”

If that’s the case, investors might want to blow out that candle.

Put simply, the Buffett indicator is the total market capitalization of all U.S. stocks relative to the country’s gross domestic product. When it’s in the 70% to 80% range, it’s go time. When it moves well above 100%, it’s time to tap the brakes.

The metric sits at almost 139% at the moment, which is getting awfully close to the record 145% it hit during the peak of the dot-com bubble in 2000, the only other time the number has been this high, according to the Daily Reckoning blog’s Jody Chudley

“The chart below shows the peak of the ‘Buffett-Metric’ in 2000 and the subsequent fall,” he wrote in a post on Tuesday. “The chart also shows how frothy the reading is on this metric today.”

As you can see, the last time this indicator reached this level, there was much carnage to follow. Chudley advises against ignoring the warning signs.

“If you stick your head in the sand and pretend that this isn’t anything to be concerned about, you aren’t going to like what comes next,” he said.

The reason, Chudley says, for the spike is different from the one driving the lofty valuations of the Pets.com days. This time around it’s about the massive flow of money into passive index funds and ETFs in recent years, as shown in this chart:

“These passive vehicles buy the exact same stocks with no thought whatsoever given to valuation,” he explained. If you give an index fund a million dollars it is just as happy to buy stocks trading at 3,000 times earnings as it is to buy stocks trading at 6 times earnings. This is mindless investing.”

“Mindless” isn’t an insult, considering that’s the whole idea of an index fund, but it can yield some “strange” and potentially painful results, Chudley said.

“All of this mindless index fund money ends up chasing the same stocks, the stocks that make up the underlying indices,” he said. “With hundreds of billions of mindless dollars chasing the same stocks, you end up with some crazy valuations.”


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