Last week, I thought back to an article that Warren Buffett wrote a few months before the great Internet bubble of the 1990s finally burst.
Today, I’m going to take a look at a valuation metric that Buffett calls “probably the best single measure of where valuations stand at any given moment.” And that is the ratio of the total market cap of U.S. stocks, as measured by the Wilshire Total Market Index, to U.S. GDP.
The thinking here is pretty straightforward. Over the very long term, the value of the stock market should move more or less in line with the economy. Individual stocks can grow at a sizzling pace as they crowd out their competition, but the value of the market in aggregate should roughly track the value of the economy.
So, with that said, let’s take a look at Mr. Buffett’s indicator, courtesy of data site GuruFocus:
Right now, the U.S. stock market is worth about 125% of the U.S. economy. In a vacuum, this is a meaningless number, but you start to notice a trend over the long term.
As you can see, today the market is roughly twice as expensive as it was in the early 1990s. And it’s only about 25% below the levels of the 2000 dot-com-mania peak.
In other words, Warren Buffett’s favorite macro valuation tool is screaming that U.S. stocks are nearing bubble territory.
Now, to be fair, there are quite a few moving parts here. As I wrote last week, corporate profits as a share of GDP are at all-time highs. And low interest rates have the effect of pushing up asset values across the board.
But while both of those factors might help to explain why stock valuations have grown this large relative to GDP, neither gives me much confidence for the future.
Corporate profits are well above the levels that Buffett believed to be sustainable, and the massive revaluation of the market due to falling bond yields has already happened. Bond yields cannot go much lower than they are today, meaning that the relative value trade here has already run its course.
None of this means a crash is going to happen tomorrow, of course. Stocks can go from expensive to more expensive. It happens all the time.
But if nothing else, this tells us that blindly throwing new money into an index fund right now is a bad idea. This is a time to stay tactical, focus on income, and look to buy pockets of value as you see them.