Buffett's favorite market tool is flashing red

This little-known valuation metric has entered familiar territory. Here's why investors should share the Oracle of Omaha's concerns -- and how they can protect themselves.

By StreetAuthority Nov 8, 2013 3:29PM
File photo of Warren Buffett on the NBC News' 'Today' show on November 27, 2012 (© Peter Kramer/NBC/NBC NewsWire via Getty Images)By David Sterman                                                                       
In the go-go days of 1999, Warren Buffett grew very concerned.

Not because his value style of investing had grown unpopular, but because investors were becoming delusional in their zeal for further gains.

In a speech he made to friends, as recounted in a 1999 article in Fortune magazine (that was published just a few months before the market peaked and then plunged), Buffett warned that "once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks."

A simple test of how much stocks were loved: The aggregate value of the largest 5,000 U.S. companies (as measured by the Wilshire 5000) exceeded the GNP of the U.S. economy. In fact, a market melt-up took this ratio up to 150% by early 2000 (meaning the Wilshire 5000 was 50% larger than the U.S. economy), which set the stage for one of the most painful corrections ever for investors.

This ratio eventually dipped well below 100%, which for Buffett has been seen as a time of deep value for stocks. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you," he told Fortune in a 2001 follow-up.

Indeed stocks went on to deliver solid gains into that decade, but by 2007, Buffett's handy ratio again flashed red. Stocks were becoming so frothy that this measure once again exceeded 100%. The resulting market blow-off in 2008 was another painful lesson for investors, but at least put the market deep into value territory, setting the stage for the bull market we've been enjoying ever since.

Yet as we head towards the end of 2013, investors need to once again tread cautiously, because Warren Buffett's market valuation tool is again in the red zone.



The Wilshire 5000 has risen 68% since the end of 2009. Yet the economy has grown just 17%, throwing this key ratio out of whack.

Is this time different?
There is a pair of pretty good explanations to justify the current 109% ratio. First, interest rates are near historic lows (though they are unlikely to fall much lower and more likely to rise in coming years, turning this tailwind into a headwind).

More importantly, corporate profit margins are at all-time highs, so every dollar of corporate sales is worth more than it used to be. What should we infer about profit margin trends and their impact on the market? Well, profit margins tend to surge in the early phases of an economic recovery as companies maintain very lean headcounts and restrain discretionary spending. Yet as an economy recovers, companies finally invest in more staff and equipment, which tends to push profit margins back down to historical norms.

And if margins have peaked, how will stocks fare? A study by Brown Brothers Harriman suggests stocks can still rise -- but on the three of the past seven times occasions when margins have peaked, stocks fell by double digits the following year.

Risks to consider: As an upside risk, robust economic growth would provide the chance for companies to maintain current margin levels, as a higher fixed overhead is matched by rising revenues. Yet few are calling for robust U.S. economic growth in coming years.

Action to take: The Wilshire-to-GNP ratio is stretched, but it could well go even higher for a while, as was the case in 1999. Yet a clear margin for error has been removed from this market, and there is ample reason to shift your portfolio into a defensive posture. That means missing out on further upside in the aggressive growth segments of the market, but also means a greater chance of capital preservation.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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194Comments
Nov 8, 2013 4:31PM
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We don't need Buffet to tell us that stocks are overpriced. Market values, corporate profits, stock buybacks, asset and commodity values, interest rates... are all based primarily on the fed's free phony money. To them the problem in 2008 wasn't the fact that housing and stocks were over priced, it was that they dropped in price. So of course their solution is to pump the prices back up. Well here we are back at 2007 prices. But they have done nothing to address the underlying problems in the economy. 

Nov 8, 2013 4:26PM
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Stock prices are inflated, tell me something I don't know please!  QE QE QE. Takes time for all that wealth to "trickle down" right?!?!?!  Where is household income these days?
Nov 8, 2013 4:41PM
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Wall street needs a good dose of the humility that the new Pope has recently demonstrated. But what we'll get is more arrogance, greed, pretentiousness, foulness, cheating, lying...
Nov 8, 2013 8:08PM
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Where is the money coming from to keep the stock market at record highs? Is it the record  49 million people on food stamps in the U. S. investing in the market and keeping it propped up? Answer is No,  your government is manufacturing "fake", worthless, unearned  money and it is being dumped into the bond and stock markets to make people think everything is fine
Nov 8, 2013 7:00PM
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Time for me to cash out and retire. I'm gonna invest in muscle cars weed and young whores now. I just don't like any of the ladies over 75 you know? And under 60 they just don't know what they're doing. 
Nov 8, 2013 4:56PM
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Well written, thought out article, without the histrionics I have come to expect from Anthony Mindinhari (sp) or Bill Fleckenstein.  The article outlines the risks and rewards, and gives a reasoned opinion as to how to allocate (or re-allocate) ones investments.

 

I, for one, appreciate investment advice given in this manner.

Nov 8, 2013 5:51PM
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So all the rich will or have profited and the poor suckers with 401"s will suffer again. 
Nov 8, 2013 5:18PM
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QE,QE,QE,QE,QE,QE,QE,   It is not a matter of if it is just a matter of when! How bad is the Obama liberal policies going to hurt everyone? Especially the poor, Retired, middle class and the minorities!

These are all the same people who vote based on two factors : 1st for the minorities Obama appears Black, Two: Obama promises to "get" the rich, to make them "pay" there share (even though most of the middle class down pay nothing) and the government will help you out>  Free rent, free food, free phone, free medical, Vote for Obama , it is not you fault, let the government take care of you! Just remember to vote democrat!

    We all know those evil republicans will pass laws that promote the "free market" not the QE government controlled market. Jobs will come back and wages will be based on your skill level , your education and you actual work performance,  not some union scale with promotions based on those who just "show up" the longest.

     So if you like living off the government being told where to live , what you can eat, drink and wait for some 3rd rate government doctor then Barack Obama and the progressive liberal socialist party is for you.

    If you want to work and get ahead, to contribute instead of always taking (like the Obama supporters) if you want to be able to take vacations, have a nice house that you own, a good car and safe neighborhood then vote republican ! 

Nov 8, 2013 3:52PM
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Still same old, same old, Buy in low and then take profits and sell when high. Things never change. Soon it will be time to pull the switch and start counting profits.


Nov 8, 2013 5:23PM
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I thought Obama was going after the wealthy.what a joke!!!!!!
Nov 8, 2013 5:52PM
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Lets see - play a game where you don't know the rules, don't control the board or don't have the information to make rational decisions.... yep - that's the Stock Market.  Question:   What makes a stock worth $35 one day and $32 the next - the answer - some pencil necked analyst fresh out of college.
Nov 8, 2013 5:29PM
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The Stock Market will soon be a falling knife.
Nov 8, 2013 6:38PM
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Another simple thing to do: find stocks that have returned higher dividends year after year for decades, check to see that the basics are still sound, and then put money in as long as the P/E is under 20. Ignore market fluctuations and maintain a 20 year timeline.  One must do one's own due diligence, but one can look up Dividend Aristocrats and start looking through them...
Nov 8, 2013 5:38PM
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GNP/GDP is measured in T, not B, 17.24T.
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Not all investment advice is good, but all of it is good for learning. In 2008 I began to apply some of the things I have gleaned from guys like Buffet and Bogle. I am not disappointed with their methods and results. You have to start some where, These ways are not a bad way to start. We'll see if I've really learned anything when the next bear starts foraging on my retirement savings. I am only five years from my target date. 

 

I'd rather be good unless I can be good and lucky.

 

besting investing to all..

JohnC

Nov 8, 2013 5:17PM
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I think the article provides worthwhile information, and Buffet may have a point...

Sorting it all out is the difficult part, times have changed for various reasons and considering all the variables takes more than a few minutes of one's time.

Nov 8, 2013 6:21PM
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Buy and hold and reinvest earnings is the way to make money over the long haul......
Nov 8, 2013 5:26PM
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get rid of the cheap money that is inflating the dow averages get back to reality and stop speculations as the CFTB is prone to do .They tell us to live within our budgets.  STOP QUESSING and live in the real would.  WHERE ARE THE JOBS.!!!!  it is a crime these money people are holding back AMERICA at a pace of 2.4 million jobs short of total employment.  If these bastards were to be in power in 1941 WEB WOULD BE SPEAKING JAPANEES!!!! today
Nov 8, 2013 5:42PM
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No skibum609, he was warning in 1999 about a market that crashed in 2000. Have you been living under a rock?
Nov 8, 2013 8:27PM
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We need a man like Warren Buffett for president and not another jerk who hands out food stamps on the street.  Those jerks need to get a job.  They could always sell their motor home or BMW.
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