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

It's no secret that stock prices are at all-time highs. This has people asking the literally trillion-dollar question: Are we in a stock market bubble? According to what is referred to as the Warren Buffett indicator, the answer to that question is a resounding yes. In this video, we are going to discuss what exactly the Warren Buffett indicator is, why it is showing that this stock market is the most overvalued in history, and why the stock market would have to fall by 50% to be considered fairly valued based on historical averages.

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The Buffett indicator is used to determine how cheap or expensive the stock market is at a given point in time. It was created by the legendary investor Warren Buffett in 2001, who called it probably the greatest single measure of where valuations stand at any given moment. In its modern form, it compares the U.S. Wilshire 5000 index to U.S. GDP. It is widely followed by the financial media and investors as a valuation measure for the U.S. stock market and has recently hit an all-time high.

The Buffett indicator is the ratio of the total U.S. stock market valuation to GDP. Or, put more simply, it is the total value of all American stocks divided by the entire size of the U.S. economy. To calculate the ratio, we need to get data for both metrics: total stock market value and GDP. To determine the total stock market value of the U.S., Buffett uses the Wilshire 5000 index.

The Wilshire 5000 Total Market Index is a broad-based, market capitalization-weighted index composed of 3,451 publicly traded companies that meet the following criteria:

1. The companies are headquartered in the United States.
2. The stocks are listed and actively traded on a U.S. stock exchange.
3. The stocks have pricing information that is widely available to the public.

The Wilshire 5000 index is a better measure of the total value of the U.S. stock market than other, more popular stock market indices that you may be more familiar with, such as the S&P 500, the Dow Jones, or the Nasdaq. In the case of the S&P 500, it only measures the 500 largest U.S. companies. The Dow Jones has only 30 component companies, and the Nasdaq consists of mostly tech companies and excludes companies listed on the New York Stock Exchange. On the other hand, the Wilshire 5000 is often used as a benchmark for the entirety of the U.S. stock market and is widely regarded as the best single measure of the overall U.S. equity market.

The current market cap of the Wilshire 5000 is approximately 47.1 trillion dollars. The next number needed to calculate the Buffett indicator is Gross Domestic Product, commonly abbreviated as GDP, which represents the total production of the U.S. economy. This is measured quarterly by the U.S. government's Bureau of Economic Analysis. The GDP is a static measurement of prior economic activity, meaning it does not forecast the future or include any expectation or evaluation of future economic activity or growth. The current GDP of the United States is 22.7 trillion dollars.

We now have the two numbers we need to calculate the Buffett indicator. We have the market value of all U.S. stocks, with the Wilshire 5000 market cap currently at 47.1 trillion dollars, as well as a current GDP of 22.7 trillion dollars. If we divide 47.1 trillion by 22.7 trillion, we get 2.075. We then multiply that number by 100 to turn it into a percentage. This means the famous Buffett indicator is at 207.5 percent.

Now that we know that the Buffett indicator is sitting at 207.5 percent, you should be asking yourself the all-important question: So what? That number is obviously useless without any historical context. Take a look at this chart, and you will see just how extreme the Buffett indicator currently is compared to historical averages.

The Buffett indicator at 207 percent is significantly higher than periods that turned out to be huge market bubbles, such as the height of the infamous dot-com bubble in March of 2000, where the Buffett indicator topped out at 140 percent. Even the top of the housing bubble in October 2007 looks extremely tame at 104 percent compared to today's level of nearly double that. Since 1970, the average Buffett indicator reading has been at around 85 percent. In fact, for the stock market to be considered fairly valued based on historical averages, the total value of the stock market would have to fall to 19.3 trillion, far from the 47.1 trillion. This means it would take a 60% stock market crash for the Warren Buffett indicator to fall back to its historical average of 85 percent.

Okay, so now that we understand where the Buffett indicator currently is in relation to historical trends, that still doesn't answer the most important question of all for you as an investor: What does this mean for future investing returns? Over the last 10 years, the S&P 500 returns have been extremely strong, at an average of 12.5 percent per year, well above historical trends. So, what is the return that we, as investors, should count on over the next 10 years?

We can look at times during both extremely high and extremely low market valuations to see how the Buffett indicator helps predict future returns in the stock market. Let's look at how Warren Buffett used the thinking around the Buffett indicator to help make predictions about future returns from the stock market during these crazy times. Warren Buffett has been known to be hesitant about making predictions about the stock market, but in my research, I located a few times where Buffett used the Buffett indicator to help make accurate predictions about the future returns of the stock market.

In November 1999, when the Dow was at 11,000 and just a few months before the burst of the dot-com bubble, the stock market gained 13% a year from 1981 to 1998. The Buffett indicator was at 130 percent, significantly higher than ever before in the past 30 years. Warren Buffett said in a speech to friends and business leaders, "I'd like to argue that we can't come even remotely close to that 13% return if you strip out the inflation component from this nominal return, which you would need to do. However, inflation fluctuates; that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more."

Two years after the November 1999 article, when the Dow was down to 9,000, Buffett said, "I would expect now to see long-term returns somewhat higher in the neighborhood of seven percent after costs." Buffett revised his expectations for future returns higher because the Buffett indicator had come down significantly from its high of 130 in November 1999 to 93 just two years later, meaning stocks were more fairly valued, and as a result, prospective future returns were higher.

Then, in October 2008, after the S&P 500 had fallen from a high of greater than 1,500 in July 2007 to around 900, Warren Buffett wrote, "Equities will almost certainly outperform cash over the next decade, probably by a substantial degree." Buffett wrote these words when the indicator was at around 60 percent. This was not a popular prediction at the time; people were selling out of stocks left and right because they were worried about the future. They had seen stock prices fall consistently and wanted to sell out of stocks before they kept falling more.

Since Buffett made this call in October 2008, the S&P 500 has returned an average annualized return of 14.7 percent, with dividends reinvested. This return is significantly higher than the long-term historical return of the stock market. To grasp why the Buffett indicator has been a good gauge of future stock market returns, you have to understand the reason stocks can't rise 25% or more a year forever. This is because, over the long term, stock market returns are determined by the following three things:

1. Interest rates: Interest rates act on financial valuations the way gravity acts on matter. The higher the interest 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 prices of all other investments upward, all else being equal.

2. Long-term growth of corporate profitability: Over the long term, corporate profitability reverts to its long-term trend, which is around six percent. 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.

3. Current market valuation: Over the long run, stock market valuations tend to revert to their 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 return.

I want to conclude this video with a couple of important points in investing. When people say, "It is different this time," it usually turns out to not actually be different this time and the historical norms of the stock market return. However, with that being said, I want to point out a couple of things that need to be considered that truly are different this time. The first is historically low interest rates. Interest rates have never been this low. Take a look at this chart of the current interest rate on 10-year U.S. government bonds. These extremely low rates help, at least partially, explain and justify the high stock market valuation by historical standards.

To use a Warren Buffett quote: "Interest rates act like gravity on stock prices. As interest rates rise, stocks become less valuable, and as interest rates decrease, stock prices increase, all else being equal."

Second, companies are staying private for longer and, therefore, these large companies aren't included in the value of the stock market. If these companies had decided to go public, the market cap of Wilshire would be higher. The Wilshire 5000 actually contains around 3,500 stocks but did hold 5,000 when it was first introduced in 1974, named for the nearly 5,000 stocks that contained at launch. The Wilshire 5000 grew to a high count of 7,562 on July 31, 1998. Since then, the count fell steadily to 3,776 as of December 31, 2013, where it has then bounced back to 3,818 as of September 30, 2014. As of 2019, the index held 3,492 stocks. The last time the Wilshire 5000 actually contained 5,000 or more companies was December 29, 2005.

Since this index only counts publicly traded companies, if large non-publicly traded companies were also included in the value of the index, that would make the Buffett indicator lower, albeit likely not by a large enough factor to put the indicator more in line with its historical values.

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