Warren Buffett Once Warned That the Stock Market Is "Playing With Fire" When His Famed Indicator Hits Over 200%. Should Investors Be Worried?

For decades, Warren Buffett has encouraged investors to maintain a long-term perspective and avoid paying too much for stocks.

In a 2001 Fortune magazine article, he described the ratio of the total value of U.S. stocks to the size of the U.S. economy as "the best single measure of where valuations stand at any given moment". It later became known as the Buffett indicator, and it's flashing a warning right now.

As of June, the Buffett indicator was at 218%. To provide some context, Buffett has said that when this indicator is in the 70% to 80% range, buying stocks is likely to work out well. However, as he said in the 2001 article, if it gets above 200%, investors are "playing with fire."

Should investors be worried?

Image source: The Motley Fool.

The Buffett indicator is flashing a warning

In isolation, it'd be easy to look at this number and conclude that the S&P 500 (SNPINDEX: ^GSPC) is overdue for a correction. That may be true, but it's important to add some context to that number.

Investors are clearly pricing in a lot of optimism about the future of artificial intelligence (AI) and are pulling forward some of those future earnings growth expectations into current prices. But I don't think that's entirely unjustified.

S&P 500 earnings growth over the past few quarters has been very strong overall, and that trend is likely to continue for at least the next few quarters. The forward price-to-earnings (P/E) ratio on the Vanguard S&P 500 ETF (NYSEMKT: VOO) is only around 20. That wouldn't just suggest an overly expensive market, although it is historically above average.

But if you look at stock prices relative to U.S. GDP, you get a different story. The important thing to remember is that no single number is an indicator that a crash is imminent. But it does suggest that investors are paying premium prices for stocks today, even with the AI boom happening in the background.

There's a problem with using it as a timing signal

At the bottom of the financial crisis, the Buffett indicator hit 70%. That was the last time it fell into that 70% to 80% range.

Now, let's imagine that you decided to sell stocks when the indicator hit 140% for the first time since the tech bubble. That would have meant you got out of the S&P 500 at the beginning of 2015. If you had stayed completely out of stocks since then, you would have missed out on a roughly 350% gain in the Vanguard S&P 500 ETF and a 650% gain in the Invesco QQQ ETF (NASDAQ: QQQ).

Metrics like the Buffett indicator can be useful, but they often fail when used as a hard buy/sell signal.

What I'd do today

Acknowledge that U.S. stock prices are high by historical standards. Don't ignore that warning, but don't rely on it solely as a justification for selling. In Buffett fashion, make sure your portfolio is appropriately diversified, consistent with your long-term goals, and acting within your risk tolerance. But maintain a long-term view.

As history has taught, some indicators can flash a warning for years. It doesn't necessarily mean that a crash is coming.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.