The Buffett Indicator Is Hitting a Level Seen Only 3 Times in the Past 60 Years. History Says What Happens Next Won't Be Good.

By most measures, the U.S. stock market is expensive right now. That shouldn't come as a surprise.

The S&P 500 (SNPINDEX: ^GSPC) trades at around 31 times earnings, a level reached during just a few periods since the late 1800s. The Shiller CAPE Ratio, which measures average inflation-adjusted earnings from the prior 10 years, just hit 40. The only other time it's hit that mark in the last 150 years was during the heights of the tech bubble.

Another popular signal is the Buffett Indicator. Given that the guy who created it is considered one of the most successful investors ever, Wall Street tends to pay attention to it.

Unfortunately, if history is any guide, it's sending a big red flag warning.

Image source: Getty Images.

What the Buffett Indicator measures

The Buffett Indicator compares total U.S. stock market capitalization to U.S. GDP. In essence, it's asking how large the stock market is relative to the size of the U.S. economy that supports it. Warren Buffett himself once called it "probably the best single measure of where valuations stand at any given moment."

For decades, the indicator hovered in a range mostly between about 40% and 100%. It crossed above the 100% level for the first time in the late 1990s as the tech bubble began picking up steam. Following bouts of volatility then and during the financial crisis, the Buffett Indicator has continued to move higher and set new records.

Currently, that ratio sits at 230%, an all-time high and about 77% above its long-term trend line.

What the indicator is telling us right now

While the absolute level of this indicator is staggering enough on its own, its relative level is the real warning signal.

For just the fourth time in the past 60 years, the Buffett Indicator is sitting two standard deviations above its historical trend line. Not only is this ratio continuing to push to new all-time highs, but it's also hitting historical highs on a relative basis, too. Never before has the Buffett Indicator signaled that the S&P 500 is this overvalued.

None of this means that a massive bear market is imminent. It doesn't signal that this indicator couldn't go even higher from here. But it does suggest that forward-looking returns are likely to be below average for years. And it's probably going to start with a significant market pullback.

Readings this high have historically preceded sharp corrections

Here are the three previous occasions where the Buffett Indicator was two standard deviations above the average and what happened next:

1. Late 1960s: By 1968, the S&P 500 was at new all-time highs. But just as the indicator was hitting extreme levels, it ushered in a bear market that saw the index fall more than 30% by 1970. The "stagflation '70s" had begun, and the S&P 500 would fall by nearly 50% from peak to valley by the mid-1970s.
2. 2000: This one probably doesn't need an explanation and is exhibit A in stock overvaluation. After peaking in March, the S&P 500 fell roughly 40% through the October 2021 low (the Nasdaq bear, of course, was much deeper). Interestingly, the price-to-earnings ratio for the S&P 500 at the peak was just over 30, right around the area it is now.
3. 2021-2022: Stock prices took off following the 2020 COVID-19 bear market as zero interest rates and trillions of stimulus dollars were used to get the economy going again. By 2021, the economy started to feel the fallout of all that liquidity in the system. The inflation rate jumped to 9% and the S&P 500 declined roughly 25% by the latter half of 2022.

Why today's Buffett Indicator reading is concerning

Now, we're at the same point again. The natural comparison might be to 2000. I think that period was clearly more speculative, and investors gave wild valuations to unproven companies. Today's market is still seeing earnings growth to support higher valuations, at least for the time being.

But it's worth repeating that all three previous instances of the Buffett Indicator getting this stretched were followed by S&P 500 declines of at least 25%.

Again, I don't think we're looking at an imminent bear market here. Underlying macroeconomic conditions are still looking favorable, so there could be support for the S&P 500 here. But I think investors should realize that future returns are likely to be much different than returns over the past three years. And volatility is likely to return at several points along the way.

This isn't a crash signal, but it is a warning. Valuations still matter, and investors should keep this in mind.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.