A popular valuation metric — known as the Buffett indicator — measures total U.S. stock market capitalization relative to domestic GDP. It currently sit at 236%, which is essentially its highest level ever. This suggests that U.S. stocks are extremely overvalued.
Is this data point flashing a warning sign to stock market investors?
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In the past decade, the S&P 500 index (SNPINDEX: ^GSPC) has produced a total return of 324% (as of Oct. 5). On an annualized basis, the 15.5% gain is significantly higher than the benchmark’s historical 10% average.
It makes sense why some investors may be worried about the market’s valuation these days. The Buffett indicator might hint at poor investment returns in the years ahead.
Investors should take the time to know this metric’s limitations, though. It doesn’t factor in foreign revenue generated by U.S. companies. Some of the largest technology enterprises, which have a huge weighting in the S&P 500 index, make a lot of money internationally. This artificially inflates the Buffett indicator’s numerator.
The money supply has also ballooned in the past 10 years. That’s a tailwind for equities since it results in more liquidity entering the financial system that can flow to stocks.
The takeaway for investors is to use the Buffett indicator to understand the current state of markets. But don’t expect this to be a tool that helps you time your buy and sell decisions. Nothing beats putting money to work early and letting compounding take over.
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