Wall Street Is Flashing a Warning Signal That's Only Appeared 4 Times in 60 Years
Key Points
Although the S&P 500 briefly topped 7,000, investors remain concerned about the monetization potential of artificial intelligence (AI) investments.
The Buffett indicator is historically stretched, signaling that the market may be priced for near-perfect execution.
It isn’t a perfect crash signal, but it can serve as a useful warning that future returns may be lower and volatility higher.
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The S&P 500 (SNPINDEX: ^GSPC) hit a historic milestone, crossing 7,000 for the first time on Jan. 28, 2026. But, the very next day, sentiment cooled after the latest earnings results of technology companies such as Microsoft and SAP disappointed investors. This has revived concerns about whether the massive artificial intelligence (AI) spending by technology giants can translate into meaningful profits in the near term.
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In this environment, Warren Buffett's favorite market valuation tool, the Buffett indicator, becomes even more relevant.
The Buffett indicator
The Buffett indicator measures the value of the entire U.S. stock market against the U.S. gross domestic product (GDP). This provides an easy way to assess whether stocks are running far ahead of the economy.
The Buffett indicator was around 230%, which is 76.6% or 2.4 standard deviations above its historical trend line at the end of the third quarter. This is also only the fourth time in 60 years that the indicator has approached or surpassed two standard deviations above its historical exponential trend line. Even at the current reading of roughly 222%, the indicator remains in extremely stretched territory.
Historically, the last three periods when the Buffett indicator reached similarly extreme levels coincided with major market drawdowns. The Buffett indicator peaked in 1968, and the S&P 500 fell over 35% from November 1968 to May 1970 during the 1970 tech stock crash. The indicator again peaked during the 2000 dot-com bubble, and the S&P 500 fell by 49.1% from March 2000 to October 2002. Finally, it reached extreme levels in 2021, and the S&P 500 dropped by 25.4% as inflation rose.
This time, however, the Buffett indicator may also seem "too high" because GDP is domestic, while many U.S. companies generate massive international revenues. Additionally, only a few megacap companies carry an outsize weight in the S&P 500, which exposes the index to sharp swings if even one or two of them witness share price declines.
The Buffett indicator is not a guaranteed crash signal. However, it can serve as a warning that future returns may be lower and volatility higher for U.S. stock investors.
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Manali Pradhan, CFA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft. The Motley Fool recommends SAP. The Motley Fool has a disclosure policy.
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