The stock market has been making a powerful rebound over the past couple of weeks. Both the S&P 500 (^GSPC -0.32%) and Dow Jones Industrial Average (^DJI -0.34%) reached new record highs, while the Nasdaq Composite (^IXIC -0.60%) has climbed by over 9% since late July, as of this writing.
However, that doesn’t mean that a pullback is off the table. Experts say that an AI bubble is the leading tail risk facing the market right now, according to Bank of America‘s latest Global Fund Manager Survey, with 45% of fund managers raising concerns.
Warren Buffett’s own favored market metric — nicknamed the Buffett indicator — is also sounding the alarm. It measures the relationship between the total value of U.S. stocks and GDP, and in Buffett’s own words, investors are “playing with fire” when it nears 200%. As of this writing, it’s at a record high of just over 232%.
So what should investors do right now? Buffett says this one investing move will be key to surviving a market downturn.
Image source: The Motley Fool.
Buffett’s warning about the dot-com bubble still rings true
Near the height of the dot-com bubble in 1999, in a speech later republished as an essay in Fortune, Buffett warned that the market was likely due for a downturn.
The S&P 500 had surged by nearly 200% between 1995 and 1999, largely because of the dot-com boom, and valuations were soaring. While there was no shortage of excitement around the internet and its impact on society, Buffett emphasized that an industry’s potential isn’t as important as many investors may believe.
He mentioned the airline industry as an example. While the invention of the airplane had an enormous global impact, Buffett noted that 129 airline companies had declared bankruptcy in the previous two decades. In other words, an industry’s ability to change the world doesn’t necessarily mean every company in that industry is a smart investment.
“The key to investing,” Buffett explained in 1999, “is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
How to prepare for an AI bubble burst
To be clear, there’s no guarantee that we’re even in an AI bubble right now. However, there are a few parallels to the dot-com bubble, and investors would be wise to prepare for volatility just in case.
The market as a whole is incredibly expensive right now. The S&P 500 Shiller CAPE Ratio — a stock market metric that tracks the S&P 500’s valuation over time — is nearing levels only seen during the dot-com bubble. While that doesn’t necessarily mean a crash is imminent, it does suggest that many stocks may be overvalued and due for a pullback.
S&P 500 Shiller CAPE Ratio data by YCharts
Now more than ever, it’s crucial to choose your stocks wisely. Some stocks may be soaring in price, but if they lack a competitive advantage, they’ll likely struggle over the long haul.
At the same time, some of the strongest long-term investments are not the flashiest. As long as a company has solid underlying business fundamentals, it doesn’t need to be groundbreaking to provide robust long-term returns.
“The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors,” Buffett said in 1999. If the market eventually does take a turn for the worse, these are the stocks that will be the safest (and most lucrative) buys.
