Warren Buffett Just Sent Wall Street a $174 Billion Warning. Here's What Investors Absolutely Must Know.

Warren Buffett has led Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) for six decades, during which he turned what began as a small textile mill into a trillion-dollar conglomerate. Berkshire stock has returned 20% annually since Buffett took control in 1965, due in large part to savvy acquisitions and prudent investments.

Buffett has traditionally been a net buyer -- meaning the value of stock he purchased has usually exceeded the value of stock he sold for Berkshire -- but he was actually a net seller during the last 10 quarters. Specifically, Berkshire bought $31 billion and sold $205 billion in stock over that period, bringing net sales to $174 billion.

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Interestingly, the trend continued in the first quarter even though the S&P 500 (SNPINDEX: ^GSPC) dropped into correction territory. In fact, Berkshire ended the quarter with a record $348 billion in cash and equivalents on its balance sheet. So, not only have Berkshire's net stock sales totaled $174 billion in the last 10 quarters, but also the company is currently sitting on a record cash pile.

There is only one logical interpretation: Buffett is struggling to find good investments in the current market environment, likely because stocks are too expensive in his estimation. Here's what investors should know.

Image source: Getty Images.

Historically, the S&P 500 has produced weak returns from its current valuation

The cyclically adjusted price-to-earnings (CAPE) ratio is a valuation metric typically used to gauge whether entire stock market indexes are overvalued or undervalued. It was developed by Nobel-winning economist Robert Shiller during the dot-com bubble, so it is sometimes referred to as the Shiller P/E ratio.

Whereas the traditional price-to-earnings (P/E) ratio is based on earnings from the last 12 months, the CAPE ratio is calculated with average inflation-adjusted earnings from the past decade. That eliminates the cyclical fluctuations that occur throughout the business cycle to produce a more accurate picture of where an index's valuation stands.

The S&P 500 had a CAPE ratio of 33.1 as of April 30. That is historically high. The index's monthly CAPE ratio has exceeded 30 on only 118 occasions since its inception in 1957, which is less than 15% of the time. After those readings, the S&P 500 has returned an average of just 4% in the next year and 23% in the next three years, excluding dividends.

Importantly, while an elevated CAPE ratio has typically correlated with weak future performance in the stock market, it does guarantee poor results. The chart below shows the range of historical outcomes following incidents when the S&P 500's monthly CAPE ratio exceeded 30.

Data source: Robert Shiller. Returns exclude dividends.

Historically, the S&P 500 has performed much better when the starting monthly CAPE ratio was below 30. Under those circumstances, the index has achieved an average one-year return of 9% and an average three-year return of 29%, excluding dividends.

How investors should interpret Warren Buffett's $174 billion warning to Wall Street

As mentioned, Berkshire has been a net seller of stocks for 10 consecutive quarters, and its net sales totaled $174 billion in that period. That constitutes a warning for Wall Street because it represents a major deviation from past behavior. Warren Buffett told CNBC in 2018, "It's hard to think of very many months when we haven't been a net buyer of stocks." That is no longer the case, nor has it been true for some time.

While Buffett's reluctance to invest hand over fist in recent quarters implies some concern about valuations, it's also a product of circumstance. Berkshire has a market value above $1 trillion, meaning no small stock purchases will move the financial needle. The unfortunate truth is Berkshire is limited in its options because few companies are large enough to be consequential investments.

Individual investors are not limited by the same problem. So, they should not interpret Buffett's warning as a call to lean away from the stock market, but rather as a reminder to be cautious because valuations are elevated. The most prudent course of action is to limit purchases to high-conviction stocks -- those whose earnings are likely to be much higher in a decade -- that trade at reasonable prices.

Likewise, investors should consider trimming any positions large enough to make them feel uncomfortable, especially if those stocks trade at expensive valuations. Anyone that loses sleep over an investment is doing something wrong. That said, I would personally never exit a position entirely unless I had completely lost confidence in the company.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.