Surprisingly few things are named after Warren Buffett. No street is named in his honor near his hometown of Omaha, Nebraska. The Buffett Cancer Center at the University of Nebraska isn't named after Warren Buffett but instead his late cousin, Fred, and his wife, Pamela. The Buffett Institute for Global Affairs at Northwestern University is named after Roberta Buffett Elliot, Warren's sister.
However, I can think of two things that bear Warren Buffett's name. The Buffett Cup is a trophy that was given to the winner of a tournament between bridge teams from the U.S. and other countries. Buffett, an avid bridge player, sponsored the contest in past years. The Buffett indicator is a gauge that measures the stock market's valuation.
One of these two is making news in the early weeks of the new year. The Buffett indicator is now at an all-time high. What does this mean? And what should investors do?
Image source: The Motley Fool.
What is the Buffett indicator?
The Buffett indicator is the ratio of the total market capitalization of all publicly traded securities to U.S. gross domestic product (GDP). Buffett didn't invent this metric, but he did make it famous.
In July 1999, the billionaire investor spoke about the stock market at a conference for corporate executives. He warned that stocks were likely to plunge. Two years later, Buffett spoke at the same event. As he predicted, the S&P 500 had fallen significantly.
Fortune magazine's Carol Loomis worked with Buffett to turn his second speech into an essay that the magazine published in December 2001. This article included a chart of the value of U.S. stocks to gross national product (GNP) -- an economic metric that has been largely replaced by the similar GDP. Buffett noted that this ratio "is probably the best single measure of where valuations stand at any given moment."
He pointed out that the ratio hit an all-time high in 2000 and stated, "That should have been a very strong warning signal." Buffett added: "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- your are playing with fire."
Soon thereafter, people began referring to this ratio as the Buffett indicator. And the name stuck.
Looking downright bubbly
The soaring stock market gains that made Buffett so nervous in 1999 later became known as the "dot-com bubble." That bubble began to burst in March 2000. By the end of 2002, the tech-heavy Nasdaq-100 index had lost nearly 80% of its value.
If Buffett's analysis from over two decades ago is still on point, the stock market is again looking downright bubbly. Remember that he cautioned in 2001 that if the ratio that now bears his name approaches 200% investors are "playing with fire." What is the level of the Buffett indicator today? Over 200%.
That said, some don't believe the Buffett indicator is as relevant as it once was. The gauge has been above its levels from 2000 for several years -- and the stock market has continued to rise. This might be in part because U.S. companies generate more revenue from outside the U.S. now, money that wouldn't be included in the U.S. GDP figure.
What should investors do?
I think investors should do what Buffett is doing with his namesake indicator at an all-time high. Most importantly, he isn't reacting rashly by bailing out of stocks. Buffett's Berkshire Hathaway equity portfolio is worth nearly $296 billion. That's a pretty good sign that Buffett isn't panicking.
The legendary investor has continued to buy some stocks, albeit not as many as in the past. This seems to show that Buffett is concerned about frothy valuations but is still able to find some stocks that meet his investment criteria. Other investors probably will be able to pick stocks that aren't too expensive as well.
Finally, Buffett has built Berkshire's cash stockpile significantly. That makes sense when there aren't many stocks to buy with attractive valuations. Whether or not the Buffett indicator's high level today still means investors are playing with fire, keeping cash on hand to take advantage of a pullback is a good idea.
