The Stock Market Just Made a Move That Warren Buffett Has Called "Playing With Fire." History Shows He's Right.

Stocks have roared higher in recent years, and even after headwinds in the first quarter, the market continued along this positive path. Investors, recognizing the growth potential of artificial intelligence (AI), have piled into players in this industry. And they've set the pace during this bull market, now in its third year.

AI is proving its ability to supercharge the revenue growth of companies involved in developing the technology -- from chip designers to cloud service providers. And this is just the beginning. When applied to real-world problems, as is being done more and more frequently, AI is making companies more efficient -- and that should boost earnings growth.

All of this has driven tremendous gains in the three major indexes, with the tech-heavy Nasdaq Composite and the S&P 500 climbing 122% and 78%, respectively, over the past three calendar years. And just this week, the Dow Jones Industrial Average, which advanced 45% over the three years, closed above the level of 53,000 for the first time.

This sounds exciting, but it's important to remain watchful of details that may offer us clues about what's next. And this is where investing expert Warren Buffett comes in. The stock market just made a move that Buffett once called "playing with fire." History shows that Buffett's words have been spot on. Let's zoom in for a closer look.

Image source: The Motley Fool.

Buffett's track record

So, first, a quick note on the importance of considering Buffett's words. The billionaire, at the helm of Berkshire Hathaway for 60 years, led the holding company to market-beating gains over that period. The compounded annual increase of nearly 20% surpassed that of the S&P 500, which was about 10%. Buffett's strategy involves scooping up shares of quality companies for reasonable prices and holding on for the long term.

The "Oracle of Omaha," as he's often called, doesn't get caught up in market trends or jump on the bandwagon -- you won't find him rushing to get in on stocks when the market is soaring, and instead, you might find him bargain hunting when everyone else is selling.

Now, let's consider the market's recent move. It's the type of move that Buffett watches so closely that the measure of it is known as the "Buffett indicator." This is a metric comparing the value of the stock market to the size of the U.S. economy. The calculation is simple: It's the total U.S. stock market value divided by the country's gross domestic product. And right now, the Buffett indicator has reached a record high of more than 235%. This shows stocks are worth significantly more than the country's output -- and suggests that the market is overvalued.

Buffett, in a Fortune article, once warned that levels above 200% are equivalent to "playing with fire."

What the S&P 500 may do next

And history shows us that the investing giant may be right. The last time the indicator surpassed 200% happened in November of 2021, and the S&P 500 then went on to decline more than 15% over the next 12 months.

^SPX data by YCharts

The other notable peak occurred back in March of 2000 during the dot-com bubble -- at that time, the Buffett indicator reached a record high of more than 147%. From that point through the end of 2002, the S&P 500 dropped 42%.

^SPX data by YCharts

All of this suggests that at today's levels, the stock market and some investors may indeed be playing with fire, as Buffett says. And if history is right, the index could be heading for a decline.

What does this mean for you as an investor? This isn't a signal to drop all of your stocks and stop investing. Instead, this trend suggests that you should pay close attention to valuation -- even if a stock is popular and the company has a great business, if it's overvalued, now isn't the moment to buy. That's because this player and other overvalued stocks might see a pullback in the months to come.

The best strategy is the following: Like Buffett, continue to buy reasonably priced or bargain stocks today or during any market environment -- and hold on for the long term.

Adria Cimino has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.