Warren Buffett: The Upcoming Stock Market Collapse (Warren Buffett Indicator)

So as we all know, 2022 was a rough year for investors in the stock market. The S&P 500 was down 18%, the Dow Jones Industrial Average was down seven percent, and the NASDAQ was down a whopping 33%. After these big declines in the stock market, one would think that now would be a good time to buy stocks, right? Well, maybe not so fast.

Warren Buffett's favorite stock market indicator is flashing warning signs that the stock market is still significantly overvalued. Warren Buffett is universally regarded as the greatest investor ever, and a large part of his success has been him being able to know whether or not it is a good time to invest in the stock market. He has been able to avoid getting caught up in stock market bubbles. He waits patiently on the sidelines until a crash happens, then buys up tens of billions of dollars in stock for huge discounts.

While Buffett is called the Oracle of Omaha for a reason, it isn't just pure intuition that allows him to seemingly time the market so well. It is backed by cold hard numbers. The metric that Buffett uses to evaluate the stock market has become known as the Buffett indicator. So in this video, we're going to cover what the famous Buffett indicator is, why it is worrisome for investors, and what this means for your money. But first, make sure to hit that like button and subscribe to the channel, because my goal is to make you a better investor by studying the world's greatest investors.

The Buffett indicator is a way to help evaluate whether the stock market is undervalued or overvalued by comparing the value of stocks to that of a country's economy. Buffett has even gone as far as to say that this is the single greatest measure of where evaluations in the stock market stand at any given moment.

Here's how the Buffett indicator is calculated: in the numerator of the fraction, we have the value of all stocks in the United States. This is the current value of the Wilshire 5000 Total Market Index. Now, this is an index that includes all publicly traded stocks. As of the making of this video, the index consists of 3,218 stocks that are publicly traded in America. Think of this as the current value of the stock market.

On the bottom of the fraction, we have America's Gross Domestic Product, or GDP. Simply put, Gross Domestic Product is the total value of the goods and services produced by a country in a specific period of time. Think of GDP as a measure of the size of an economy; the larger the GDP, the larger the economy.

Once you divide the value of the entire stock market by the size of the economy, you multiply that number by a hundred to get a percentage. The higher the percentage, the more expensive the stock market is, and the lower the percentage, the cheaper the stock market is, and in theory, the better the time is to buy stocks.

Just as a quick example, let's see the value of all stocks is eight trillion dollars and the value of the economy is 10 trillion. Once we divide the value of the stock market by the size of the economy, we get 0.8 and then multiply that by 100 to get us reading of the Buffett indicator of 80. Think of the Buffett indicator almost like a P/E ratio for a stock. A P/E ratio is calculated by taking a company's stock price and dividing it by its earnings per share. So if a company’s stock is trading at thirty dollars a share and it did two dollars in earnings per share, the P/E ratio is 15.

The same basic logic applies to the Buffett indicator, but instead of the price of one stock, the Buffett indicator uses the value of all stocks in the top of the equation, and instead of earnings per share, it is the total value of the economy. It makes sense that the size of the economy is used because the profitability of the stock market as a whole is tied directly to the health of the economy. As the economy grows, it's better for the companies that operate in that economy; a larger economy means there are more opportunities for companies to sell their goods and services and make more money for investors.

So now that we have that background, let's see where the famous Buffett indicator stands today. But before we do that, I want to play a little game. What do you think the Buffett indicator is? For reference, the long-term average of the Buffett indicator is around 88 percent over the last 50 years, and I will give you a little hint: the Buffett indicator is currently sitting at above its long-term average. But how high exactly? Maybe it's at 90 percent, or a hundred percent, or maybe even a hundred and ten percent. Well, let's do the math and find out.

The total value of the U.S. stock market is at 43.7 trillion dollars; that goes on the numerator of our fraction. The most recent estimate for the GDP of the United States, think of this as the size of the total economy, is 26.1 trillion. Doing this math gives us a Buffett indicator of a whopping 167 percent! That's nearly double the long-term average of the Buffett indicator, suggesting at first glance that the stock market is significantly overvalued.

However, I do think the answer is a little bit more nuanced than that. Despite the higher-than-normal Buffett indicator, I think there's some more context that needs to be added. While it appears that the stock market is incredibly overvalued currently, there is also an argument to be made that it actually isn't that overvalued. I want to cover both of these perspectives in this video so you can decide for yourself.

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Now back to the video! Let's first start with the argument for why the stock market is overvalued. The obvious answer to that is to look at the Buffett indicator and compare it to its historical levels. There is no question that it is currently elevated relative to the last five decades. The data is also pretty clear that whenever the Buffett indicator is extremely elevated, investors experience lackluster returns over future years.

Take the year 2000 as an example. The Buffett indicator peaked at around 150 percent at the height of the dot-com bubble. The S&P 500 also peaked that same year at a value of around 1500. Where do you think the S&P 500 was 10 years later in 2010? Believe it or not, the S&P 500 had only recovered to 1100. This means that people that invested at the peak of the market, when the Buffett indicator was flashing warning signs, had an average annual return of negative three percent over that 10-year period. This number excludes dividends but still shows how it was a period of lousy returns for investors.

The peak of the Buffett indicator in 2000 was actually how Warren Buffett popularized the metric. He was invited to attend and speak at the famous and exclusive annual Sun Valley Media Conference. For those of you who don't know, the Sun Valley Conference is one of the premier business conferences around. It is invite-only, and the guest list is the who's who of the business world. Just take a look at last year's guest list: Bill Gates, Liberty Media's John Malone, Comcast chairman Brian Roberts, Alphabet CEO Sundar Pichai, Apple CEO Tim Cook, Nike founder Phil Knight—the list goes on and on.

The point is that this event is full of some of the most important people in the business and investing world. Well, in 1999, the invite list was full of newly minted millionaires and billionaires who made a fortune, at least on paper, from crazy high stock prices of their newly founded technology companies. Being the most well-known and highly respected investor in the world, Buffett was naturally asked to give a speech on, of all things, the stock market.

Buffett got up in front of the crowd and introduced what is now known as the Buffett indicator. He explained that the Buffett indicator was at all-time highs and that current stock prices had to come down at some point. Buffett was calling the market a bubble. As I'm sure you can imagine, the audience was, well, let's just say not very receptive to his presentation. Actually, that's an understatement. People were mad. They started calling Buffett washed up and behind on the times.

While it turns out Buffett was right, the stock market bubble burst, and it took investors 15 years to finally reach the highs again that the stock market hit in 2000. I tell the story to demonstrate one thing: the Buffett indicator does have a good track record of helping predict future returns of the stock market. Based on where the Buffett indicator is sitting now, it seems safe to say that the next 10 years in the stock market won't be nearly as good for investors as the last 10 years were.

There is also something a lot of people miss when they're talking about the Buffett indicator. This little tweak to the Buffett indicator actually shows that the stock market is more overvalued than what the traditional Buffett indicator shows. This would be adding the value of large private companies to the calculation of the Buffett indicator.

There's been a trend in recent decades of large companies not entering the stock market. Instead, more and more large companies are deciding to stay what is referred to as private, meaning that the average investor can't buy and sell shares of the company because those shares aren't traded on an exchange like the New York Stock Exchange or the NASDAQ. This trend is even reflected in the name of the index that is used to calculate the traditional Buffett indicator, the Wilshire 5000. This index is called the Wilshire 5000 because when it started, there were 5,000 publicly traded companies in America. That number has since reduced down to 3,218.

Given that the number of publicly traded companies in America is constantly changing, it just doesn't make sense for the index to be continuously changing its name. I mean, the Wilshire 3,218 doesn't quite have the same ring to it. When you add the estimate for the value of all large private companies in America, the Buffett indicator shoots up to a value of 235 percent—more than double the long-term average of this adjusted Buffett indicator of 110.

This is another way of looking at the Buffett indicator that suggests the market is even more overvalued than what the traditional Buffett indicator would suggest. Even though this video up to this point has been pretty negative, it isn't all completely doom and gloom. The first piece of good news is that even though the Buffett indicator is elevated relative to historical levels, it has come down from its all-time highs in 2021.

As we can see in this chart here, the Buffett indicator was at nearly 200 percent towards the end of 2021, and it makes sense that the Buffett indicator has since decreased. The numerator, or the value of stocks, has obviously decreased. The S&P 500 is down roughly 15% since late 2021—that's nothing compared to the NASDAQ that is down nearly 30% over that same period.

On the other side of the equation, over the past 12 to 18 months, the economy has continued to grow and recover. GDP is larger than it was at the time the Buffett indicator was hovering around 200%. A decline in the value of stocks and a larger economy resulted in the Buffett indicator coming down to a somewhat—key word here being somewhat—more normalized level. The decline in the Buffett indicator also aligns well with the moves Buffett has been making in the Berkshire Hathaway stock portfolio.

In 2021, Warren Buffett really was not buying any stocks. In fact, he actually sold more stocks than he bought that year. Instead, he spent tens of billions of dollars repurchasing Berkshire Hathaway shares. Compare that to 2022; just through the first nine months of the year, Buffett bought a whopping 66 billion dollars for the Berkshire portfolio.

So despite the stock market being overvalued based on the Buffett indicator compared to historical levels, Buffett was still able to find attractive stocks to buy. So this leads me to something important that I want to cover in the remainder of this video: maybe comparing the current Buffett indicator to historical levels is not the right way to go about it. And here are three reasons why.

The first reason is that interest rates are much lower now than they were in previous decades. In fact, interest rates have been on a steady decline since the 1980s. Take a look at this chart here of the U.S. Federal Funds Rate, a proxy for interest rates in the economy. As we can see here, interest rates were nearly 20% in the early 1980s. Since then, interest rates have been on a steady march downwards, even bottoming out at zero percent and staying there for a while. Despite the fact that interest rates have risen rapidly in recent months, they are still well below long-term historical averages.

The reason that this matters is that interest rates impact the value of stocks. As Warren Buffett says, rising interest rates act like gravity on stocks—or put another way, the higher the interest rates, the lower stock prices will be. The alternative is also true: low interest rates are like jet fuel for stock prices, shooting them upwards to crazy high prices. Part of the reason stock prices are higher now than in other times in history is because interest rates are still very low. This can cause some issues comparing the Buffett indicator at various points in history. If interest rates are low, it would make sense that the Buffett indicator is higher because stocks should be worth more.

The second potential issue with the Buffett indicator is that it only measures the value of the U.S. economy in its calculation. However, each and every year, companies become more and more global. Take Buffett's largest position, Apple, as an example. Roughly two-thirds of Apple's revenues come from outside the United States. Apple is definitely unique in that the majority of its sales come from international markets. However, the average company in the S&P 500 has about 30 percent of sales come from outside the United States. As companies continue to do more and more business outside of America, the Buffett indicator becomes less accurate by only including the size of the U.S. economy in its calculation.

The third reason why the Buffett indicator may be higher now than it historically has been is because companies today are more profitable than in previous decades. Take a look at this chart from research firm Yardeni Research. The average profit margin of a company in the S&P 500 was 5.5 percent in 1994. That has since risen dramatically all the way to 13 percent in 2022. If you were an investor in the stock market in 1994, for every dollar of sales a company did, only 5.5 cents of that would fall to the bottom line in the form of profit for you as an investor.

However, by 2022, that number has skyrocketed to 13 cents of profit for each dollar of sales. If you're an investor, obviously, you want to invest in a more profitable company because that means more profit for you as the owner. As a result, the more profitable a company is, the more it is worth and the higher premium investors place on that company.

If you take a look at the Buffett indicator over time, while it sure does have its peaks and valleys, it has trended higher over time. I think this version of the chart really shows what I'm talking about. You can see that over time, the average Buffett indicator score has moved up year after year. I think a large part of that is explained by the fact that companies have seen their profitability move upwards over time.

That's why it may not be entirely fair to compare the Buffett indicator now to what it was in 1970, for example. Companies are more profitable and do more business outside of the United States. So there we have it! I hope you enjoyed the video, so make sure to hit the like button and subscribe to the channel because our community of investors is approaching 200,000 people strong, and it would be great to have you join. Talk to you again soon.