Is the Buffett Indicator Flashing a Warning Sign to Stock Market Investors?

The last decade has been phenomenal for investors. The S&P 500 index (SNPINDEX: ^GSPC) has delivered a 322% total return (as of Oct. 23) during that time. After such a superb performance, the market has valuation concerns.

Warren Buffett first mentioned what became known as the Buffett indicator in 2001. It divides the total value of U.S. stocks by U.S. GDP (gross domestic product). A high reading might suggest that the market is overvalued relative to the economy, while a low reading can signal that it's cheap.

Currently, this metric is at 234%. That's near the highest that it's ever been.

So, is the Buffett indicator flashing a clear warning sign to investors? Here's what you need to know about the stock market right now.

Image source: Getty Images.

Waiting for a pullback

The initial reaction from investors is that the stock market is currently extremely overvalued. The benchmark index has climbed at an annualized pace of roughly 15% in the past 10 years. This is much higher than its historical yearly average of 10%.

Besides the Buffett indicator, which obviously gets a lot of attention because of who it's named after, the cyclically adjusted price-to-earnings (CAPE) ratio, now at 40.6, is also at extreme levels. It was only higher during the dot-com bubble period at the turn of the 21st century. At that time, the Buffett indicator was around 135%. That's considerably lower than where it currently sits.

The 2000s were a disappointing decade for stocks, though there was a severe housing-led recession toward the end of the decade. It's also worth highlighting Warren Buffett's interpretation. A reading above 120% could be considered expensive. This means that the next 10 years may yield very poor returns.

Understanding this backdrop, it's easy to understand why investors might adopt a cautious view. A bear market, defined as a drop of at least 20% from a recent high, could always be on the horizon. And there's a possibility that the economy slips into a recession.

Plus, it's impossible to ignore how important artificial intelligence (AI) has become. If the spending boom shows any signs of slowing, it could trigger a bear market and a recession.

Don't sit on the sidelines

The smartest investors take the time to understand the current environment. However, they also know that this time is different. The Buffett indicator has shortcomings. Therefore, I don't believe it's a warning sign.

This figure fails to account for overseas revenue generated by companies. The economy has only become more global and interconnected. And many of the largest businesses in the U.S. have substantial operations in foreign markets.

This is especially true for major technology enterprises. They generate a lot of sales outside the U.S. This isn't reflected in the GDP figure, which is the denominator of the Buffett indicator. And given their massive scale, they account for a sizable share of the stock market, as reflected in the numerator. That creates an imbalance.

There's also significantly more liquidity in the economy and financial system. The M2 money supply has expanded rapidly in the last two decades, going from $6.9 trillion to $23.3 trillion today. This is due to the Federal Reserve's monetary policy decisions. There's no doubt that some of this capital has flowed to equities, adding buying pressure to stocks and lifting valuations.

Informed investors should be aware of the Buffett indicator. However, they shouldn't use it as a predictive tool to time the market. Trying to avoid downturns usually backfires, as it's virtually impossible to successfully trade in and out of positions on the right days.

Historically, the S&P 500 index has posted positive gains over every rolling 20-year period. That's really the only data point to focus on. Optimism and patience are rewarded in the stock market.

Neil Patel 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.