Market indicator favored by Buffett flashes red

The last 2 times this happened, the market tumbled sharply. Is the Oracle right this time?

By StreetAuthority Apr 1, 2013 4:36PM
By David Sterman                                                  

What are stocks worth?

That's a loaded question. Any stock can appear overvalued or undervalued, depending on which valuation metrics you use.

The same logic applies to the broader stock market. Right now, some think the market is undervalued as the U.S. economy appears poised for a solid long-term upturn. Others think we're headed for a market downturn, as the Federal Reserve winds down its aggressive liquidity-boosting efforts.

Yet by at least one measure, which happens to be a favorite market gauge for Warren Buffett, the market has just become overvalued.

The economy and the market
Buffett thinks the value of all stocks in the Wilshire 5000 Total Market Index should be lower than the U.S. gross national product. The GNP stood at $16.13 trillion at the end of 2012, according to the Bureau of Economic Analysis. Well, the Wilshire 5000 hit that mark on March 4, and has subsequently risen to $16.57 trillion. That difference may seem trivial, but history tells us the gap should be seen as a sell signal.

The Wilshire 5000 index was created in 1974 to capture the total value of the 5,000 largest companies on the various U.S. stock markets. (An aside: The steady attrition of publicly-listed companies during the past decade means there are now fewer than 5,000 companies in the index.)

Since the advent of the Wilshire 5000, it has exceeded the value of the U.S. GNP on only two occasions: 1998 and 2007. In each case, the market rose yet higher but eventually tumbled sharply. In fact, after the threshold was crossed in 1998, the market rose another 40%. Nonetheless, the market eventually stumbled so badly (as the Wilshire 5000 fell a hefty 40% from its March 2000 peak) that investors had a right to be nervous throughout the latter stages of that rally.

Nearly a decade later, in 2007, the Wilshire 5000's value again exceeded the size of the U.S. GNP, and this ratio soon moved up to 105%. But by the year's end, the index began to slump, foreshadowing an eventual market rout in 2008.

As far as Buffett is concerned, even a return below 100% of GNP doesn't spell opportunity. He thinks stocks are truly appealing when this measure falls below 80%. This helps explain why he's been an aggressive buyer of stocks in the midst of deep sell-offs.

An inexact correlation?
There is a bullish argument to be made that "this time is different." After all, corporate profit margins are near all-time highs, so although the Wilshire 5000 might be in the danger zone in the context of the size of the U.S. economy, it may not be so alarming in the context of corporate profits.

By that logic, it can be argued that an expansion in the value of the Wilshire 5000 depends on stability or growth in corporate profit margins. However, companies have maintained very lean workforces for half a decade and will need to start expanding head count if the economy grows. In such a phase of the U.S. economic cycle, profit margins tend to compress as overhead expenses rise. 

Sell in May?
There's an adage on Wall Street that it is wise to "sell in May and go away." And in each of the past three years, we saw a significant springtime pullback. In light of the robust start to 2013, you need to heed the seasonal trends. The Wilshire-to-GNP ratio highlights that concern.

To be sure, the coming earnings season is expected to be generally positive, but the first-quarter earnings season has also proved to be a great time to take profits.

Risks to Consider: The Wilshire-to-GNP ratio could move higher in the near-term, so this isn't necessarily a signal to short the market or sell your stock positions. 

Action to Take: As portfolios expand in value on the backs of an extended market upturn, investors need to heed all of the traditional signals. This warning signal is flashing red in tandem with a range of technical indicators that signal overbought conditions. That makes this a fine time to lock in profits on your top-performing picks (while holding firm with your more value-oriented or income-producing portfolio holdings). Raising cash now could help provide the ammo for the next buying opportunity if we see a sharp market pullback.

More from StreetAuthority
Apr 2, 2013 9:12AM
hmmm...   Lets say the GNP is 16.2 trillion....  our debt is 16.7 trillion or 103% of GNP?   

This will not end well...
Apr 1, 2013 6:37PM
I am 75% cash now, and actually antsy for a big drop. I hope to see a 15-20% drop. Buy low, sell high!
Apr 2, 2013 10:13AM

The economy and stock market is like a puppet show without the curtain….everybody can clearly see the puppeteer (big daddy Bernanke) and the strings.  But the whole audience is saying "wow, isn't this economy spectactular, we are pulling out of recession, we are moving forward", as they either refuse to see the puppeteer (Bernanke) or just plain don't get it.

Apr 2, 2013 8:29AM
I somehow doubt this theory. In a world where nothing has real value due to the massive amount of Global Money Printing, how can any true value be assigned to anything. Maybe it had some merit before the Current Global Money Scams.

History has already shown that Markets can  far exceed expected upside or downside regardless of fundamentals. Since the FED and others are buying DEBT, whose to say they aren't doing the same with stocks. In the end, we all know this can't last. Anyone guessing that date will be doing just that, guessing.

Apr 1, 2013 6:24PM

"should be worth fewer than the U.S. gross national product "


Worth fewer what?

Apr 2, 2013 9:21AM
Yeah, and a gallon of gas tends to cost just about as much as a gallon of milk.  But the correlation isn't that cows drink gas.  It is more complicated than looking at just one or two key metrics...  Besides, if this article is right about Buffett then why is the guy buying Heinz right before a market crash?
Apr 1, 2013 5:20PM
A very interesting and well written Article David....Easy to understand,etc....Thanks.
Apr 2, 2013 9:20AM
In Aug China hosts a Asian financial summit and Federal reserve seeks to renew it's one hundred year charter. I'd bet that China convinces meeting delegates to drop dollar as world reserve currency. That causes financial markets to tail spin. In turn bolsters support for the Federal reserve that is causing US dollar to lose value. No way this can go on and no exit plan, opened ended mile stones to increase interest or cut buying debt.  
Apr 2, 2013 10:50AM
Have been 75% in the market past 3 years.  Waiting for pullback to invest the rest.
Apr 2, 2013 10:58AM

It`s all about buying the rock solid stocks.I could name 10 or so stocks that did

well through the 2001 crash and the 2008 crash.

Apr 2, 2013 1:28PM

ALIAS BARRY:I could verbally rip you a new one, but us Democrat can disagree without

being a horse`s.Unlike you I`m educated.Besides if I got nasty, you`ld post it and hury my chances for running for Pres. in 2016.I might need help passing a bil as Pres with LOG CABIN REPUBLICANS

like yourself.

Apr 2, 2013 12:22PM
Stop all the gov intervention of pumping money in the economy, stop bailing out banks etc. and see how the market reacts and then you will see the truth as to the market correction.
Apr 2, 2013 12:43PM

ALIAS BARRY SOETORO:Well, I see Mr. Negative is still around.I heard a rumor you were going to

see the light and start believing in Obama`s Presidency.So, what if the market is up over 100%

in the last 4 years and all the economic indicators are up.You need me to disagree with

you.Everybody who knows you just walks away from you and considers the sourse.Don`t

worry about my name.I`m sure your not Barry.

Apr 2, 2013 3:58PM

ABS....Replied on your, fishing expedition and questions.


Yeah only about 56-57 more comments, you had better hurry and figure it out...

Remember we are one of eight.???  Kinda like 7 of 9..

Apr 2, 2013 12:32PM

My oh my, ABS....That certainly puts it all in the street, in one easy comment.


About 70 or so comments to go, you can hold my feet to the fire then....?

Mr. Danz (Mr. Brucey's cousin) is here working, I have to ride herd on him, so he doesn't fall off a ladder or get stuff in his eyes, from not wearing the Safety glasses I provide...


With Garden,Golf, lawn, remodeling, fishing and a little trading on Wall St.....Just won't have much time to be on here....The world is changing, and I've grown weary, of the politics and information, commenting that doesn't pertain to anything about investing...When it includes rants..

Apr 2, 2013 9:39AM
This is ridiculous!!! The 2008 stock market crash was caused by a scare due to the massive collapse of the american real estate bubble and the recession that followed. Right now the US economy in a slow recovery mode.

The world is today very different from 1974, S&P500 companies do a much larger share or their business outside the US therefore comparing their price to the size of the US economy makes less and less sense.

I'm not selling anything, will buy more on dip.

Apr 2, 2013 11:16AM

BUFFET...Probably bought Heinz as a hedge against another possible recession...?


That's what would happen if Repubes got their wish for a collapse of 15-20% of the Markets..

Then they would have another nail for the crucification or a "we told you so.."


Campells and other soup companies, usually do okay in those times and recover more quickly.

Apr 1, 2013 7:24PM
A 20% drop is 3000 points...It will send us back into a recession.....I hope you are kidding..?
Apr 1, 2013 7:21PM
I caught that too Usher...But knew what he meant, I guess?
Apr 2, 2013 11:09AM

If the market was doing this great with a Republican president can you imagin how

the Republicans would be worshiping the President.Right now the Repubs are coming

up with all kinds of lame duck excuses why the market has been on fire.The fact

that corporate profits are way up as are all the other economic indicators doesn`t change

their far right mindset

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