Forget the CAPE Ratio. This Other Buffett Indicator Just Crossed a Line

"The Buffett Indicator is calculated by taking total U.S. stock market capitalization, or market cap, and dividing it by U.S. GDP. It basically answers the question: How large is the stock market relative to the economy that supports it? In a 2001 interview, Buffett called that indicator "probably the best single measure of where valuations stand at any given moment." And its average historical range is roughly 75% to 90%. Levels above that range suggest the market may be getting ahead of underlying economic growth."

"Overvalued stocks are a problem because they represent a disconnect from fundamentals like earnings and growth potential. When the market on a whole is overvalued, a correction - and sometimes a steep decline - can follow. That could lead to big portfolio losses. The Shiller CAPE ratio has long been a popular measure of whether stocks are expensive or not. It measures stock prices relative to average inflation-adjusted earnings over the past 10 years."

"Knowing that, it may or may not surprise you to learn that the Buffett Indicator is dramatically higher today. As of this writing, it's at 226%. For context, during the dot.com peak in 2000, the Buffett Indicator reached about 140%. And most of us know what happened next. Once that bubble burst, stock values plummeted, and that crash lasted a good two and half years. Reading between the lines, a value of 226% signals that stocks may be extremely overvalued - and that a decline may be coming."

The goal of long-term investing is to earn money by buying quality stocks and holding them for many years. Overvalued stocks can disconnect from fundamentals such as earnings and growth potential, and broad market overvaluation can lead to corrections or steep declines that cause large portfolio losses. The Shiller CAPE ratio measures stock prices relative to average inflation-adjusted earnings over the past decade. The Buffett Indicator uses total U.S. stock market capitalization divided by U.S. GDP to show how large the stock market is relative to the economy supporting it. Its historical range is about 75% to 90%, while current levels around 226% are far above that range. The dot-com peak reached about 140% before a major crash lasting roughly two and a half years.

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