The Warren Buffett Indicator Shows the US Stock Market Is Dangerously Overvalued by 200%

The 2000s Dotcom Bubble is tiny compared to the current one, according to data from the US Bureau of Economics Analytics.

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Image Credit: GerryMiller/GettyImages

“Buy stocks” is the typical throwaway investing strategy given out online.

Buy the index,” they say.

Working in finance for many years has forced me to loath these phrases. They’re throwaway lines, dished up in personal finance books, designed to upsell investing products.

If investing was as simple as “buy stocks,” we’d all be millionaires. I’d funnel my entire paycheck into US stocks and never look back, if all you needed to know was “buy the US Index Fund and you can’t go wrong, buddy.” There are so many hidden secrets of stocks.

There is gambling… and investing.

Gambling is believing the stock market hype. Gambling is having zero financial education.

Investing is looking at the data to see what it tells you, and managing risk accordingly.

Right now in the US there is record unemployment. Some argue the unemployment rate is improving. But that assumption forgets there is a lot of underemployment too. You might have a job, but you could be earning 40% less than last year. Politics hides this reality.

CNBC reports that “the United States economy is set to fall by 4.3% this year, but the economic contractions in the UK, France, Italy and Spain are around 10%. With lockdowns returning in Europe due to the pandemic, the decline in GDP is far from over.

The point of reminding you of all of this isn’t to make you fearful or to destroy your optimism. It’s to highlight the issue with stocks, and people flocking into them in ignorant bliss like a game of poker at the local Casino.

Earlier this year I sold my entire investment portfolio. This allowed me to lock in a 30% profit and sit on the sidelines for a while. The primary reason I did this is that stocks were, and still are, overvalued. It doesn’t take a genius to figure it out.

You could argue that stocks will always go back to the same old highs again. But there’s more to the story.

What the Warren Buffett Indicator Reveals

Warren is so successful at investing that he has his own indicator. Many people are unaware of it.

While Warren’s indicator is only one set of data points, it sure does paint a simple picture to help put stock prices into perspective. Yahoo finance explains how the Warren Buffett Indicator works:

“The Buffett indicator is calculated by dividing the total value of all stocks in the US market and by the gross domestic product of the US. Traders typically use the Wilshire 5000 Total Market Index as a measure of total US. market cap.”

Let’s get to the good stuff. The Warren Buffett Indicator reveals stocks are dangerously overvalued by more than 200%.

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Image Credit: US Bureau of Economics Analysis/fred.stlouisfed.org

One of the biggest stock bubbles in history was the Dotcom Bubble. It was during the dawn of the golden age of the internet where anyone with a website and a bobsled looked like a hero you should throw wads of cash at.

The euphoria was out of control. It resulted in a massive recession and a collapse in stock prices. Look at the chart above. The 2000s Dotcom Bubble is tiny compared to the stock bubble we’re in right now.

You might think everyday people are aware of the Warren Buffett Indicator and being cautious. You’d be wrong. Euphoria is back again.

Wall Streets’ nickname for retail investors is “dumb money.”

Wall Street act like Robinhood in reverse. They take money from the poor and give it to the rich. Right now they’re having a laugh at all the retail investing.

Retail investors are still flocking to stocks, fuelled by cheap investing advice you can get from places like Youtube, that sheepishly says “buy stocks.” As a result, retail investors are currently willing to pay about double the historical average for stocks (see chart below — average is around 16).

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Image Credit: multpl.com/shiller-pe

Roughly 20% of the stock market is retail. 80% is institutional investors — vanguard, BlackRock, JP Morgan, pension funds, etc. The reason institutional investors keep buying stocks and joining the retail investors in fuelling the bubble is because they feel The Federal Reserve has their back. “Don’t fight The Fed,” they say.

The Federal Reserve controls how much money is in the US economy. Right now they are creating money out of thin air as the central bank. So far they have created trillions of dollars from nothing.

Creating money out of thin air is easier than taxing people.

Paying tax is something everybody notices. The cost of printing money out of thin air and devaluing your purchasing power is something many people are unaware of. So, central banks and governments keep doing it.

Institutional investors are aware of the problem and place their spare cash into financial assets like stocks to retain their purchasing power. They’re happy to do this because they know The Federal Reserve has their back and will cover up any cracks in the financial system with freshly printed money.

There’s a limit to how much money a country can print though. Eventually, printing money out of thin air leads to inflation. In the short-term, it’s all gravy baby.

Where does newly created money go?

Into assets like stocks. Historically, if you own stocks, then great. You will make money. If you don’t own assets like stocks, your money is devalued and your purchasing power decreases.

Except…

When the recession forces stocks go down to meet economic reality.

Stock prices reflect overconfidence and hype. Stock prices are predicting the future — where the economy bounces back strongly. If that doesn’t happen then stock prices will have to adjust to meet reality.

The Risk of US Stocks

The contrarians argue that it doesn’t matter if stocks are overvalued by 200%. “Buy and hold has always worked,” they say. That logic only applies if you live in a bubble.

The best example in history of overconfidence in stocks and money printing going wrong is Japan’s Lost Decade. Japan still hasn’t fully recovered. They too thought stocks would go up forever and the Bank of Japan could keep buying financial assets to save the markets through quantitate easing.

If Japan suffered from hype, overconfidence, and too much intervention from governments and central banks, what makes the US invincible? Well, roughly 80% of global trade is done in US dollars because it is the World’s Reserve Currency. Perhaps that means the US can survive the crisis longer.

The problem is other parts of the world like Europe and China want to challenge the US’s world reserve currency status. The world reserve currency has changed multiple times in history. It could definitely happen again.

Popular Investor and the Chairman of Bridgewater Associates, Ray Dalio (popularised by Tony Robbins), goes one step further. He looked at history for answers. He argues that there are cycles where the world order changes and so does the world reserve currency — they’re inevitable. He claims another big change is due, which could change the US’s dominance over financial markets.

I haven’t decided whether I agree with Ray’s opinion. But it’s ignorant not to at least look at his research.

One thing was obvious to me: nothing stays the same when it comes to finance. Blatantly stating that the US stock market has always gone up, and will continue to do so, is ignoring what has happened in places like Japan and what history shows through Ray’s research.

Takeaway

The US Stock Market is detached from the economic reality. This can only last for so long. Eventually, the stock market and the economy will align again. It happened in 2008 and it will happen again in 2021 and beyond.

What does all of this mean for you? A lot. Here’s what is important to keep in mind:

  • Stocks are overvalued. No doubt about it.
  • The world reserve currency can change, and does change.
  • Money created out of thin air acts like a hidden tax. Real tax is too hard to get people to agree on. Hidden tax is easier for society to stomach.

It’s not the end. It’s not a doomsday scenario. The world is changing and that normally happens for the better.

Power has to shift so changes can occur.

Without change, humanity stays the same and our plight as a species is threatened by the Earth we occupy and the collective human psychology that can force us to fire bombs at each other.

Ditch the cliche personal finance advice.
Become a real investor through data.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.

Written by

Aussie Blogger with 100M+ views — Writer for CNBC & Business Insider. Inspiring the world through Personal Development and Entrepreneurship www.timdenning.com

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