After a brief tumble last week, major market indexes are soaring yet again. The S&P 500 (^GSPC 1.21%) and the Nasdaq Composite (^IXIC 1.34%) are inching closer to new all-time highs, up by 26% and 34%, respectively, over the past 12 months, as of this writing.
Whether or not all this growth is sustainable, however, is the question on many investors’ minds. Although no stock market indicator can predict the future with 100% accuracy, there’s one metric Warren Buffett favors that is sounding the alarm right now.
Image source: The Motley Fool.
The Buffett indicator is reaching new heights
During the lead-up to the bursting of the dot-com bubble in the early 2000s, Buffett predicted that stocks were overvalued and would soon plunge into a bear market.
Now nicknamed the Buffett indicator, the metric behind his prediction measures the ratio between the total value of U.S. stocks and U.S. gross domestic product (GDP). The higher it climbs, the more likely it is the market is overvalued.
“If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you,” Buffett explained in a 2001 interview with Fortune magazine. “If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.”
As of this writing, it sits at around 233%. This metric also peaked at around 193% in November 2021, just before the market descended into a slump that would last most of the following year.
To be clear, this doesn’t mean a stock market crash or correction is imminent. The Buffett indicator has been steadily increasing for years, and it hasn’t been below 100% since 2013. With company valuations surging with the rise of the tech sector, it’s somewhat normal for this metric to trend upward.
The single best move investors can make right now
No stock market indicator can predict the future, but it doesn’t hurt to be cautious right now in case history is on the path to repeating itself. If a market downturn is on the horizon, the stocks you choose will make or break your portfolio.
Some stocks are incredibly overvalued right now, and they may not hold up during the next bear market. If you’re buying at record-high prices and those stocks crash hard, you risk locking in steep losses.
Healthy stocks from fundamentally sound companies are far safer investments. They will also experience pullbacks, especially if the overall market turns for the worse. But given enough time, they’re more likely to recover and go on to earn positive total returns.
The more of these stocks in your portfolio, the better off you’ll be — no matter what the market throws at you.
