The US stock market is once again at the point of overheating: Buffett indicator, which measures the ratio of market capitalization to GDP, reached historical highs. Currently, its value exceeds 200%, which is significantly higher than historical averages. In 2001, Warren Buffet himself called such high levels of “playing with fire”.
The current value of Buffett’s indicator has exceeded as many as two standard deviations from the norm – this level used to usually precede large-scale collapses. Does this mean an imminent crisis? What is behind the dangerous signals and how could it affect investors, the global economy and the financial future of millions of people?
The “Oracle of Omaha” himself repeatedly emphasized that buys assets only when he believes they are undervalued, and when the market is overheated, his strategy involves accumulating cash for future opportunities.
At the beginning of this year, Berkshire Hathaway, which is owned by Buffett, accumulated a record $325 billion in cash. That’s more than the combined reserves of Apple, Microsoft, Alphabet, Amazon and NVIDIA. This could mean that Buffett is wary of possible market overheating and preparing for future investment opportunities. Although he has not officially commented that this is directly related to Buffett’s indicator, his actions are consistent with his traditional investment approach of not buying at the height of bubbles.
On the other hand, the fact that Buffett withdraws assets into cash can in itself increase the negative sentiment in the market. Investors who follow his decisions may start to follow suit, leading to a domino effect. In the past, similar periods of cash accumulation by Buffett preceded crises, for example in 2000 and 2008. But this does not mean that a crash is inevitable, because the market can remain overheated for a long time before a serious correction occurs.
What is the Buffett indicator and what are its limitations
This indicator helps to assess how well the stock market corresponds to the country’s economy. It is calculated by dividing the total value of all public companies by the country’s GDP. If the result is close to 100%, the market is considered balanced. If the value exceeds 100%, it may indicate that the market is overheated.
Historically, when the Buffett indicator has been high, it has often preceded major market declines. For example, before the dot-com crash in 2000, the indicator was at its peak. Now its level is even higher than those historical highs, which causes concern among investors.
The current growth of the Buffett indicator is possible to explain in that large-scale fiscal and monetary stimulus by the US government and the Federal Reserve led to a significant increase in liquidity in the markets, which pushed stock prices higher. Significantly affected the total market capitalization, increasing the indicator, and the growth of the capitalization of the technological giants Apple, Microsoft and Amazon.
However, while the Buffett indicator is useful for evaluating the market, it has its limitations. Many US companies earn a significant portion of their revenues outside the US, which can distort the relationship between market capitalization and domestic GDP. The transition to a knowledge economy and the growth of the service sector may also affect traditional valuation metrics.
Some analysts believe that the current economic conditions are different from the past, so high values of the indicator do not necessarily mean an imminent collapse. However, it is worth being careful, as historical data shows possible risks.
What is the Buffett indicator and how does it work?
There are many indicators in the world of finance, but the Buffett indicator stands out for its simplicity and effectiveness. A recognized investor himself named this indicator “probably the best single indicator of where grades are at any given time”.
This is how the values of this indicator are interpreted. If the indicator is less than 75%, the market is considered undervalued, a value of 75-100% is a marker that the market is in a normal state, at 100-125% the market may be overheated. Finally, the figure is above the usual 125% – and currently it is above 200%! – signals a high risk of a financial bubble.
These thresholds help investors assess the current state of the market and make informed investment decisions. And the Buffett indicator remains an important tool for assessing the state of the market and making informed investment decisions.
What fueled the market hype and does Buffett’s high indicator mean an imminent crash
In recent years, the US Federal Reserve has been cutting interest rates and implementing quantitative easing, which means injecting large amounts of cheap money into the financial system. This encouraged investors to invest in stocks and other risky assets, which led to to a significant increase in market capitalization.
The true symbols of the modern market boom have become Apple, Microsoft, NVIDIA and Tesla, whose shares have risen to astronomical valuations, significantly affecting the overall market capitalization. Quite a natural question: whether answer these valuations of the real value of companies, or are we witnessing another bubble ready to burst?
It is worth considering that many American companies earn a significant part of their revenues abroad. It increases their market value, but is not reflected in US GDP. Therefore, Buffett’s indicator may be inaccurate because it does not take into account the global nature of modern business.
So, the combination of aggressive monetary policy, the rapid growth of technology giants, the globalization of business and the possible formation of a financial bubble creates a dangerous cocktail that could lead to serious consequences for the world economy.
Some analysts consider, that the current level of the Buffett indicator shows that the market is overheated. So the question arises: are we not on the verge of another catastrophe? Opinions of experts were divided.
Here are some arguments for a possible market crash. In the past, when Buffett’s indicator exceeded 100%, it often preceded market crashes. Yes, the year 2000 is remembered by many as the dotcom crash. An indicator before the collapse of technology companies exceeded 140%, signaling the overheating of the market. On the eve of the global financial crisis – 2008, this indicator reached 110%, after which the market experienced a significant decline.
In 2021, the indicator established a new record, exceeding 200%, which raised concerns about the possible formation of a financial bubble. Finally, the current indicator level again exceeds 200%, which creates similar risks of market overheating and possible collapse.
Conditions for a financial bubble created aggressive economic stimulus and low interest rates that led to excess liquidity. A sign of overheating, similar to the dotcom bubble, maybe be the rapid growth of shares of technological giants.
Among the arguments against the inevitability of collapse, it is worth noting the following. The modern economy – compared to the past decades – has changed a lot. The growth of the IT sector and the globalization of business have changed the market, so traditional indicators can be less relevant. Many American companies earn a significant portion of their revenue overseas. It increases their market value, but is not reflected in US GDP. Therefore, Buffett’s indicator may be inaccurate because it does not take into account the global nature of modern business.
The current monetary policy and the high level of liquidity in the market can support the increase in share prices, even if the Buffett indicator points to a possible overvaluation of the market.
… Next time we will explore whether there are alternatives to the Buffett indicator that can trigger a stock market correction and how investors should act in such conditions.
Tetyana Viktorova
