Warren Buffett’s Gauge Signals the Stock Market Is Now ‘Playing with Fire,’ Prompting Questions About the Next Crash

(SeaPRwire) –   If Warren Buffett feels anxious, chances are you and I ought to feel the same way.

The Oracle of Omaha has long adhered to a simple principle for assessing whether the stock market is undervalued, fairly valued, or overvalued. His core argument: Over the long term, the total value of U.S. stocks can’t outpace the growth of businesses as reflected in GDP. So when the ratio of the S&P 500 to national income deviates sharply from the norm, it’s bound to swing in the opposite direction and “revert to the mean.” During the dot-com bubble, in a 2001 piece he wrote, Buffett highlighted a chart showing that at the frenzy’s peak in March 2000, that figure—now known as the “Buffett Indicator”—hit a lofty 200%.

“The chart’s message,” he noted, “is that if the relationship [between total equity value and GDP] drops to 70% or 80%, buying stocks is likely to work out very well for you. If it approaches 200% as it did in 1999 and 2000, you’re playing with fire.” Indeed, by the time Buffett’s story was published, the S&P had already fallen more than 20%, and by mid-2022 it had retreated almost half from its peak, pushing the Buffett Indicator below 80%. As Buffett’s formula predicted, the aftermath of the tech boom proved to be an excellent time to buy.

Which brings us to the present. Since the stock market decline triggered by the unexpected start of the Iran war, the S&P 500 has rebounded to a near all-time high of 7165. Here’s the shock: The Buffett Indicator now stands at 227%, roughly one-sixth higher than the “prepare-for-a-roasting” zone Buffett identified. This elevated reading comes with two problems. First, corporate profits have been growing far faster than GDP. Bulls claim this trend justifies today’s valuations, and that EPS can keep rising at double digits while national income creeps along at a nominal 5% or so. But this argument is dubious: Profits now make up 12% of GDP, compared to a historical average of 7% to 8%. In our highly competitive economy, fat margins attract competitors looking to grab a share of the action—they push down prices and expand volumes to steal market share from profit-rich incumbents. Extraordinary earnings growth rarely stays extraordinary. As the late Nobel Prize-winning economist Milton Friedman told the author, “Corporate earnings as a share of national income cannot stay above their historic share of GDP for long periods.”

Second, stocks have also become much more expensive relative to their profits. The S&P 500’s price-to-earnings ratio based on forecast Q1 GAAP net earnings exceeds 28—two-thirds higher than the 100-year average of around 17. The most likely outcome: Both profits and P/Es will trend back toward normal levels, pulling the Buffett Indicator and the S&P down with them.

How severe could the drop be, based on past instances of an astronomical Buffett Indicator? The decline from the dot-com-driven 200% mark that prompted Buffett’s article was about half. In November 2021, the Indicator reached just above that fearsome benchmark, then tumbled 19%.

In the article, Buffett warned that if investors expected shares to surge higher when his Indicator was hovering at those historic highs, “the line would have to go straight off the chart”—meaning optimists were banking on a suspension of economic gravity. Right now, bulls are in control, and they’re predicting the Buffett Indicator—already in uncharted territory—will push further into the “playing with fire” realm. Buffett’s thesis doesn’t predict when the market will swing back to balance, only that it eventually will, and when it does, all investors will feel the pain.