Warren Buffett: The Coming 45.1% Stock Market Reset

Warren Buffett's favorite measure of the health of the stock market is sending some serious warning messages. In fact, the so-called Warren Buffett indicator is projecting that the U.S. stock market has to fall by a whopping 45.1 percent in order for the stock market to be considered fairly valued. We're going to get into more detail on the specifics you need to know later on in this video, but first, a little story.

The year was 1999. Warren Buffett was an attendee at the exclusive Sun Valley Conference in Idaho. This annual event is invite-only, and its attendee list contains some of the biggest names in business and finance. During that year, for background, 1999 was the peak of the infamous dot-com bubble. The stock market had been soaring to sky-high levels, seemingly shattering a new record every single week. The tech-heavy NASDAQ index had rallied from 1500 in January 1995 to as high as 8,500 by the soon-to-be peak in February of 2000.

The stock market bubble was driven by young internet companies with virtually no revenue or profits who had become the darlings of the stock market, companies like Pets.com, Webvan, and Boo.com. These companies had little to show in the way of actual financial success. However, even more importantly to Wall Street at the time, these companies were internet-based. In the minds of Wall Street, these businesses were destined to be massively profitable one day as the internet continued to grow in popularity. This optimism came at a hefty price tag. During the dot-com bubble, these internet companies saw their valuations soar to billions of dollars, making their founders and early investors rich and famous. As a result, many of these newly minted billionaires were invited to the Sun Valley Conference in 1999.

Many of those invited to the conference were asked to give a presentation about a topic of their choosing. For days, Buffett listened to these newly minted wealthy founders give talks about how stock valuations didn't matter and that the stock market was going to continue to rise forever. Finally, the time came for Buffett to speak his mind. The keynote presentation at the end of the multi-day conference was none other than Buffett himself, sharing his thoughts on the stock market. Buffett got up on stage in front of a room full of new internet millionaires and billionaires and proceeded to explain to them, in his own folksy way, why all of them were wrong.

Buffett went on to explain how the stock market was incredibly overvalued. He argued that stocks were pricing in an excessively optimistic future. To make this point, he compared the total market capitalization of the stock market at the time to the size of the economy. Stock prices were so inflated that the value of the stock market was significantly larger than the size of the U.S. economy. Buffett explained how this was unsustainable, and the stock market would have to decline significantly at some point.

As I'm sure you can imagine, the newly rich internet executives did not like what Buffett had to say, both in public and behind his back. Many of these people claimed that Buffett was out of touch and washed up. They said Buffett simply could not grasp the fact that this time things were different. Oh, the famous last words of investing: "This time is different."

After the conference, the stock market continued to soar, initially proving Buffett wrong and adding fuel for those telling him to finally call it quits. The conference was held in July of 1999. The NASDAQ hit 4,800 that month, more than tripling from January 1995. Buffett's warning did little to stop the mania occurring in the stock market over the next few months. The madness continued, culminating in the NASDAQ hitting a peak of 8,500 in February of 2000. However, Buffett's prophecy came true—the bubble finally burst, and it was painful. Over the next couple of years, the fortunes made in the dot-com bubble were wiped out. Companies went bankrupt. Turns out Buffett was right; they don't call him the Oracle of Omaha for nothing. The NASDAQ index went to fall roughly 80 percent over the next couple of years. In fact, it wasn't until the year 2018 when the NASDAQ finally fully recovered to the level it achieved in the peak of the dot-com bubble.

I tell this story to demonstrate a very important point: the Buffett indicator has proven to be incredibly powerful in helping determine when the stock market is overvalued. Buffett himself even went as far as to call the Buffett indicator "probably the best single measure of where valuations stand at any given moment."

We're going to spend the rest of this video going into detail on how the Buffett indicator is calculated and why the current reading is sending warning signs to investors. The Buffett indicator is a simple fraction and can be calculated using elementary-level math. On the top of the fraction, we have the total value of the entire U.S. stock market. The most common measurement of the aggregate value of the U.S. stock market is the Wilshire 5000, named for the nearly 5,000 stocks it contained at launch. The Wilshire 5000 grew to a high count of over 7,500 in 1998. Since then, the number of stocks the index includes has fallen to the current level of 3,660 as of March 31, 2022. The index includes all U.S. equities with readily available prices, with thinly traded and bulletin board issues excluded.

On the bottom of the fraction, we have the gross domestic product, or GDP for short, of the United States. GDP represents the total annual production of the U.S. economy. In simple terms, think of this as simply the size of the economy. GDP is measured quarterly by the U.S. government's Bureau of Economic Analysis. It is a static measurement of prior economic activity, which means it does not forecast the future or include any expectation or valuation of future economic activity or economic growth. Dividing the value of the stock market by the size of the economy leaves us with a value for the famous Buffett indicator. The calculation yields a decimal format value that is most often expressed as a percentage. For example, a calculation of 1.10 would be expressed as 110 percent.

The goal of the Buffett indicator is to get a sense of whether the stock market is overvalued or undervalued relative to the size of the economy. If the value of the stock market is too large relative to the economy, it may be a sign that the stock market is overvalued and investors are overly optimistic about future prospects for a company's profits. The opposite is also true: if the size of the stock market is low relative to the size of the country's economy, the stock market may be undervalued, and it could be a great buying opportunity.

Take a look at this chart here. The blue line represents U.S. GDP. The red line is the value of the U.S. stock market using the Wilshire 5000 as a proxy. As we can see historically, GDP goes up relatively steadily over time in the absence of any major economic shocks. Our blue line is smooth and up and to the right. Contrast that with the value of the stock market, the red line here in this graph. We can see that the red line is very choppy, reflecting the volatile nature of the stock market. This volatility can create wild swings for the readings of the Buffett indicator and explains why it is such an important metric for us as investors to follow and understand.

So, with that background, where do you think the Buffett indicator currently stands here in the year 2023? I'll give you a little hint: the longer-term average of the Buffett indicator, going as far back as the data will allow, is 100 percent. So, maybe the current reading is 105, maybe 110, or even 120. Well, boy, are you in for a surprise.

Let's see where the Buffett indicator stands currently. On the top of the equation, we have the current market cap of the Wilshire 5000 index. As of July 2023, this value stood at 48.97 trillion dollars. Yes, that's trillion with a T. On the bottom of our equation, we have the U.S. GDP. The current GDP stands at 26.91 trillion. Dividing these two numbers gives us a current Buffett indicator reading of a whopping 182 percent. As we can see in the chart here, the Buffett indicator is extremely elevated relative to historical levels. This suggests that the stock market is overvalued and the future returns in the stock market will be low as a result.

Let me explain. According to Buffett, over the long term, returns that investors can expect to receive from the stock market are determined by three things. The first is interest rates. Here's what Buffett had to say on the topic: "Interest rates act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull." That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So, if the government rate rises, the prices of all other investments must adjust downward to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the price of all other investments upward.

While Buffett's explanation explains how things should work, that's not always how things turn out in practice. Over the last 18 months, higher rates have not slowed down the stock market, and this spells potential future trouble for investors. Take a look at this chart of the yield, aka interest rate, on a 10-year U.S. government bond. This is the so-called risk-free rate Buffett was referring to. We can see that the risk-free rate rose from approximately 1.5 percent at the start of 2022 all the way to nearly 4.5 percent currently. The risk-free interest rate rose by a factor of three. Based on Buffett's earlier explanation, one would think that the stock market would be down, right? Well, that's not been the case. The S&P 500 stock market index is up 15 percent so far this year, despite interest rates continuing to climb.

The fact that interest rates continue to rise, and the stock market continues to climb further, bolsters the argument that the stock market may be overvalued. The second factor that determines long-term returns in the stock market is growth of corporate profitability. In simple terms, the more profitable a company is, the more highly valued that company is in the stock market, all else being equal, of course. Over time, as the companies that make up the stock market generate larger amounts of profits, it is sensible that the stock market as a whole will rise. During recessions, corporate profit margins shrink, and during economic growth periods, corporate profit margins expand.

However, long-term growth of corporate profitability is closely tied to long-term economic growth. This is why Buffett uses the size of the economy, as measured by GDP, in the Buffett indicator. The third factor that determines future stock market returns is current market valuations. Over the long run, stock market valuations tend to revert to the long-term historical averages. A higher current valuation certainly correlates with lower long-term returns in the future. On the other hand, a lower current valuation level correlates with a higher long-term future return.

We can see at the peak of the stock market bubble in March of 2000, the Buffett indicator was approaching a value of nearly 150 percent. This was by far the highest the Buffett indicator had ever been. At this high valuation, it led to poorer future returns. It wouldn't be until the year 2013, a full 13 years later, until the S&P 500 was consistently above levels it achieved at the peak of the bubble in 2000. That means people that invested at the peak of the market in 2000 experienced a 13-year period where the stock market generated a zero percent return for them, excluding dividends. For investors in the NASDAQ, that period of zero percent returns would last an excruciating 15 years.

Okay, so all of this brings me to the trillion-dollar question I want to answer in this video: how far would the stock market have to fall to be considered fairly valued by the Buffett indicator? Well, let's find out. For the Buffett indicator to decline to 150, assuming the size of the economy stays the same, the value of the stock market would have to fall from its current value of 48.97 trillion dollars to roughly 40.4 trillion dollars. This would be a decline in the market of roughly 18 percent. If we want the Buffett indicator to get to 120 percent, the value of the stock market would have to decrease to 32.3 trillion dollars, a fall of more than 34 percent in the stock market. If we wanted to get really extreme and say the Buffett indicator had to get to 100, things would look even worse. The value of the stock market would have to decline all the way to 26.9 trillion dollars. This would mean the stock market would have to fall by a massive 45.1 percent.

Now, as alarming as that sounds, there are some other possibilities. Maybe the Buffett indicator is going to remain elevated relative to historical levels moving forward. Who knows? Maybe the Buffett indicator is no longer a relevant metric for evaluating the stock market. The other possibility is that there isn't a dramatic stock market crash. Instead, stock prices remain at current levels for years while the size of the economy grows to eventually catch up with the stock market. Either way, I know one thing for sure: it will be very interesting to see how things end up playing out.

So there you have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon. [Music]