It is a gauge that is championed by Warren Buffett.
Stocks got a bit of a valuation reset in the first half of the year, as many of the Magnificent 7 and large cap high-fliers came back to earth a bit. But in the past four months, those same stocks have taken off again, many of them blasting to new highs while pushing their valuations higher and higher.
While the gains are always welcomed, investors need to watch out for a market that is too overvalued. When a market is overvalued to a high degree, that means that the earnings may not be able to meet the lofty, inflated prices. That, in turn, can lead to stocks crashing and tumbling back to earth.
So, the question is: Are stocks currently overvalued to the extent that investors should be concerned?
One key gauge – called the Buffett Indictor — says yes.
What Is the Buffett Indicator?
The Buffett Indicator is, of course, refers to the chairman and CEO of , Warren Buffett. It is a metric that Buffett himself said is the best way to gauge the overall valuation of the stock market.
The Buffett Indicator simply looks at the ratio of the total market cap of the stock market to the overall gross domestic product, or GDP, of the U.S. economy.
As of June 30, the total market cap of the US stock market was about $65.5 trillion. The total GDP was about $30.2 trillion. So if you divide the total market cap by the total GDP, the result is a Buffett Indicator of 216%. As of August 26, the Buffett Indicator was 213%, according to MacroMicro.
Buffett Indicator Is Ridiculously High Right Now
The current Buffett Indicator is abnormally, unusually high. Put it this way, a range of 75% to 90% is considerable reasonable. Anything over 120% is considered overvalued. A Buffett Indicator of 213% is off the charts.
For perspective, the Buffett Indicator is currently at its highest point since at least 1980. That’s even higher than the 2000-era dotcom bubble when it surged to 140%. But more recently, it is higher than the 2021 post-COVID tech bubble when it rose to 202% in August of 2021. And in late February of this year, just before the market tanked, it was at 205%.
Market crashes and bear markets followed in all three of those cases.
How To Tell if a Stock Is Overvalued?
Does that mean that the markets will crash or correct in the coming months? It is, of course, impossible to predict. But investors should be wary of valuations when investing.
The simplest way to gauge whether an individual stock is overvalued is its price-to-earnings (P/E) ratio. A “good” or reasonable P/E ratio varies depending on the company. A high growth firm like is pretty much always going to have a higher P/E than say a bank like .
But what investors want to look for is a P/E ratio that has zoomed beyond its recent historical average. So, if a stock typically has a P/E ratio of around 30, and its current trading at 50 or 60 times earnings, or more, that’s probably a red flag that should be investigated.
For context, the current P/E ratio of the is around 36, which is unusually high. Typically, it is in the 25 to 30 range. Further, the inflation-adjusted 10-year Shiller P/E ratio is at almost 39 – which also screams overvalued. The last time this gauge was this high was in 2021, and the bear market of 2022 followed.
So, this is definitely a time for investors to be mindful of stock valuations.