• The Buffett Index shows that US stocks may be overvalued.

• The index was coined by Warren Buffett and measures the total cap of the US market relative to GDP.

• “If the ratio gets close to 200% — as it did in 1999 and part of 2000 — you’re playing with fire,” Buffett said in a 2001 Fortune article.

by Warren Buffett favorite stock market valuation index it just hit a record high, signaling that stocks may be extremely overvalued.

The Buffett index, which measures the overall cap of the U.S. stock market relative to U.S. GDP, hit an all-time high of 200 percent on Monday, surpassing the record high of 197 percent set in November 2021.

In other words, the total US market capitalization of about $55 trillion, as measured by the Wilshire 5000 index, is about twice the annual US GDP, which is about $27 trillion.

The stock market experienced a painful one-year bear market shortly after the Buffett Index peaked in November 2021.

In a 2001 Fortune article; Buffett called the index “probably the best single measure of where valuations are at any given time.”

When the index reached an “unprecedented level” during the 2000 dot-com bubble of about 190%, “that should have been a very strong warning signal,” Buffett said in the article.

“To me, the message of this chart is this: If the ratio falls in the 70% to 80% range, the stock market is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2,000 — you’re playing with fire,” Buffett said.

Fast forward to 2024, and it looks like investors are playing with fire.

In a note Thursday, B. Riley strategist Paul Dietrich pointed to the unprecedented reading in the Buffett Index as a reason why investors they should be careful in stocks.

In a conversation with Business Insider this week, fund manager Chris Bloomstran of Semper Augustus said that while the Buffett Index is somewhat of a flawed tool, it’s worth paying attention to as an investor.

“I think there’s utility in that, and that it’s probably a bad reset sequence, and there’s validity to that,” Bloomstran said.

However, investors must apply an “uptrend channel” to the index to account for changes in today’s economy compared to the economy in past eras.

The US economy is structurally different now than it was a few decades ago, with significantly higher corporate profit margins, more business activity through the technology sector, a more globalized economy, and significantly different levels of interest rates and inflation.

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“So if earnings are higher, margins are higher, of course the price you pay for earnings, the P/E multiple, if you hold the P/E constant, you apply it against the higher margins, so that’s going to drive grow your market capitalization relative to GDP,” Bloomstran explained.

“You can’t say, compare today’s market to 2000 compared to 1929, because those metrics were so different at those different intervals,” Bloomstran added.

But despite the Buffett index’s flaws, it flashes a big warning sign for stock market investors at current levels, according to Bloomstran.

“I think it screams the Wilshire 5000 [and] the S&P 500 is incredibly dangerous today. I think if you own the S&P 500 in an equity-weighted setup, you’re in trouble,” Bloomstran said. “It’s a world cutting edge.”

Read the original article at Business Insider