The Warren Buffett Indicator Shows the US Stock Market Is Dangerously Overvalued by 200%
By: Tim Denning
Tags: Economy, Society, Money, Education, Life

“Buy stocks” is the typical throwaway investing strategy given out online.

“Buy the index,” they say.

Working in finance for many years has forced me to loath these phrases. They’re throwaway lines, dished up in personal finance books, designed to upsell investing products.

If investing was as simple as “buy stocks,” we’d all be millionaires. I’d funnel my entire paycheck into US stocks and never look back, if all you needed to know was “buy the US Index Fund and you can’t go wrong, buddy.” There are so many hidden secrets of stocks.

There is gambling… and investing.

Gambling is believing the stock market hype. Gambling is having zero financial education.

Investing is looking at the data to see what it tells you, and managing risk accordingly.

Right now in the US there is record unemployment. Some argue the unemployment rate is improving. But that assumption forgets there is a lot of underemployment too. You might have a job, but you could be earning 40% less than last year. Politics hides this reality.

CNBC reports that “the United States economy is set to fall by 4.3% this year, but the economic contractions in the UK, France, Italy and Spain are around 10%. With lockdowns returning in Europe due to the pandemic, the decline in GDP is far from over.

The point of reminding you of all of this isn’t to make you fearful or to destroy your optimism. It’s to highlight the issue with stocks, and people flocking into them in ignorant bliss like a game of poker at the local Casino.

Earlier this year I sold my entire investment portfolio. This allowed me to lock in a 30% profit and sit on the sidelines for a while. The primary reason I did this is that stocks were, and still are, overvalued. It doesn’t take a genius to figure it out.

You could argue that stocks will always go back to the same old highs again. But there’s more to the story.

What the Warren Buffett Indicator Reveals

Warren is so successful at investing that he has his own indicator. Many people are unaware of it.

While Warren’s indicator is only one set of data points, it sure does paint a simple picture to help put stock prices into perspective. Yahoo finance explains how the Warren Buffett Indicator works:

“The Buffett indicator is calculated by dividing the total value of all stocks in the US market and by the gross domestic product of the US. Traders typically use the Wilshire 5000 Total Market Index as a measure of total US. market cap.”

Let’s get to the good stuff. The Warren Buffett Indicator reveals stocks are dangerously overvalued by more than 200%.

Image Credit: US Bureau of Economics Analysis/fred.stlouisfed.org

One of the biggest stock bubbles in history was the Dotcom Bubble. It was during the dawn of the golden age of the internet where anyone with a website and a bobsled looked like a hero you should throw wads of cash at.

The euphoria was out of control. It resulted in a massive recession and a collapse in stock prices. Look at the chart above. The 2000s Dotcom Bubble is tiny compared to the stock bubble we’re in right now.