What This Rare Historical Market Signal Means for Your Portfolio

No one can really know what the stock market will do next, yet we still look for clues or signals. Given that the S&P 500 (SNPINDEX: ^GSPC) has actually posted double-digit gains in six out of the last seven years, it's especially reasonable to wonder when the next market pullback will happen -- because it will happen, and we just don't know when.

One measure some investors look to for a clue about future market moves is the "Buffett indicator" -- and it just hit an all-time high. Here's what that could mean for your portfolio.

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Meet the Buffett indicator

The Buffett indicator is a ratio -- dividing the total value of the U.S. stock market (as measured by, say, the FT Wilshire 5000 (SNPINDEX: ^W5000) index of the total U.S. market) by the size of the U.S. economy (as measured by our gross domestic product, or GDP).

It's called the Buffett indicator because in a 2001 Fortune magazine essay, Warren Buffett referred to it, saying that: "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work out very well for you. If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire." Yikes!

You'll recall, of course, the famous internet bubble burst in 2000, leading many to embrace the Buffett indicator.

What's the Buffett indicator saying now?

So where are we now? Well, the indicator's long-term average is about 164%. And just a few days ago, it climbed above 230%. So we are definitely in nosebleed, or "playing-with-fire" territory, according to this measure.

It would then follow that the indicator suggests a significant stock market pullback is coming. What should we do about this?

Well, we investors have a few choices:

• We could sell much or all of our stocks. This could save a lot of our portfolio's assets if the market plunges soon. But what if it doesn't? We could be stuck on the sidelines through another year or two of double-digit gains that defy various ominous market indicators.
• We could just sit tight, aiming to hold on through whatever comes. Most pullbacks last a few months or years, and the market has always gone on to hit new highs. But of course, each one is different, and the next one could last years. Remember that anyone who has made lots of money in the market over decades has certainly held on through ups and downs.
• We might compromise, selling some of our holdings. This way, we'll have some cash on hand for whenever there's a pullback and be able to pounce on great stocks at better prices. Of course, the cash we have may sit and grow a little for us for a while.
• We might rearrange our portfolio, trading some overvalued growth stocks for undervalued dividend payers that should pay out in any kind of economy.

There's no way to know exactly what to do, so think about what move will give you the most peace of mind. Much depends on your risk tolerance and how long you intend to be investing in stocks.

Selena Maranjian 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.