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Forget trying to run complicated calculations or read the stock market's tea leaves. Warren Buffett says the "single best" way to tell if stocks are too expensive is to look at two simple numbers: the total value of all equities in the market and the total size of the economy.
Then compare them.
When the value of all stocks is 80% or less than the size of the economy, "buying stocks is likely to work very well for you," Buffett wrote in an article for Fortune back in 2001. But when total equity value exceeds the size of the economy and then some, it's a sign that investors are getting too giddy — and greedy.
Today, Buffett's favorite market indicator is flashing its biggest warning sign yet.
The value of all the equities in the Wilshire 5000 Total Market Full Cap Index (a proxy for the entire domestic market) stands at $26 trillion. That's 135% of U.S. gross domestic product (GDP), according to figures tracked on a quarterly basis by the Federal Reserve Bank of St. Louis.
By this measure, stocks are frothier than they've ever been — even in the months leading up to the 2000 dot-com crash or the global financial panic that began in 2007.
Now, when Buffett wrote about this indicator in the pages of Fortune, he used GNP (gross national product), not GDP, as a measure for U.S. economy activity. There's a slight difference in the two numbers.
GDP — which grew in popularity as an economic data point in the past quarter-century, and is now the more widely cited figure — measures all economic activity within the nation's borders, even if that output is generated by foreign citizens or companies. GNP, on the other hand, focuses on the output of Americans, even if they are generating that economic activity outside the U.S.
If you use GNP in this ratio, this indicator is not technically at an all-time high — but it's still getting oh so close.
The record for U.S. stock market capitalization to GNP, based on quarterly economic data, was achieved in the first quarter of 2000 — when the market was 136% of the size of the U.S. economy — based on data gathered by the St. Louis Fed. Today, that figure is about 134%.
The long-term historic average is less than 74%.
Recently, Buffett has been mum about this indicator, but he may be letting his portfolio do his talking for him.
Those high market valuations may be precisely why Buffett's investment company, Berkshire Hathaway, is sitting on a record $100 billion of cash on hand. (The company as a whole is valued at $449 billion).
Buffett is on record as saying he actually hates cash, because "cash is going to become worth less over time. But good businesses are going to become worth more over time," he says.
Yet what Buffett hates more is overpaying for his investments. So the fact that he is willing to hold so much of his company's assets in cash is a testament to how few bargains he sees in this market. And that would confirm what Buffett's favorite market indicator is now signaling.