Warren Buffett gave investors a remarkably simple warning 25 years ago.
Now the market has blown straight through it.
In a 2001 Fortune article, Buffett called the value of publicly traded U.S. stocks relative to the economy “probably the best single measure of where valuations stand at any given moment,” Business Insider noted.
His danger zone was clear: Investors were “playing with fire” if the ratio hit 200%.
GuruFocus data through October 2023 show that a frequently tracked version of the metric was 238.2% as of Sept. 4. Another computation puts it close to 241%, showing how various methodologies can yield different results.
In any case, equities have shot over the threshold that Buffett originally tied to high valuations.
But there’s another figure that investors should consider.
Berkshire Hathaway (BRK.A) (BRK.B) held $359.2 billion in cash, cash equivalents, and U.S. Treasury bills at the end of June. Together, they suggest a more fascinating question than whether Buffett is forecasting a disaster.
That is, what happens to future returns when investors pay historically extraordinary prices for the American economy?
Warren Buffett drew his line at 200%
The so-called Buffett Indicator measures the worth of publicly listed U.S. enterprises against U.S. economic production.
The principle is simple. Stocks are claims on companies, and those firms function within an economy. As their total market value rises far faster than economic production, investors are paying larger and larger multiples for those claims.
Buffett wrote about the friendship in Fortune in 2001, according to Business Insider.
The 70%-to-80% range has traditionally been great purchasing area, he noted. But as the ratio neared 200% on the eve of the dot-com boom, investors were playing with fire.
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At roughly 238%, today’s reading is about 19% above Buffett’s old 200% warning threshold.
That doesn’t automatically imply a crash is on the way.
The indication itself is somewhat limited. American corporations earn significantly more abroad now than they did decades ago, and interest rates and changes in the mix of public and private business might affect what’s considered a sensible price.
But it’s difficult to see beyond the size.
Berkshire Hathaway has $359 billion waiting
Buffett’s actions are another element of the picture.
Berkshire’s insurance and other operations ended June with $359.2 billion in cash, cash equivalents, and Treasury bills. That contrasts with $340.8 billion invested in equity and fixed-maturity securities (excluding equity-method investments).
Put another way, Berkshire’s war chest of cash is still substantial, even after putting capital back to work.
The company bought OxyChem for $9.4 billion in January and Taylor Morrison Home for $6.8 billion in July, CNBC confirmed. Berkshire bought $4.8 billion of Treasury stock in the first half, mostly in the second quarter.
This is a key difference.
Buffett’s big cash balance doesn’t indicate he thinks all stocks are expensive. Berkshire is still discovering particular plays.
It does, however, show the organization’s selectivity.
Buffett delivered a similar message at Berkshire’s annual meeting in May, warning about increased speculative behavior in financial markets and saying gambling activity was distorting pricing and making it tougher to locate good assets.
The Buffett Indicator carries an important catch
That 238% statistic makes for very scary comparison to the dot-com bubble.
But investors should not see it as a countdown clock.
Since Buffett initially called attention to the metric, the structure of corporate America has altered substantially. U.S. corporations today produce a big chunk of their revenues abroad, but the gauge relates those global companies to economic activity at home.
That can structurally lift the ratio higher.
The Buffett Indicator is a better measure of valuation than a measure of market timing.
And here is where today’s reading is more helpful.
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A costly market might continue to become pricier. It can also provide robust profit growth that ultimately justifies some of those premiums.
Harder is what usually makes beginning prices higher, without correspondingly extraordinary profit growth, to provide exceptional long-term gains.
That would put immense pressure on the AI growth.
Investors aren’t only wagering that artificial intelligence will revolutionize the economy. At present levels, they are increasingly gambling that corporations can make enough revenues from that change to justify prices that already indicate huge confidence.
Buffett’s warning isn’t really about a crash
The temptation is to make the Buffett Indicator a forecast that equities are poised to fall.
Buffett never made such a promise to investors. His initial thesis was about the link between the price paid by investors and the return they may anticipate. That difference is especially relevant now.
Berkshire isn’t just standing still. Sitting on hundreds of billions of dollars in cash, it has bought shares and made acquisitions. It’s more about selection than plain bearishness.
Perhaps the most beneficial interpretation is a 238% reading.
Extreme values don’t have to wait for a market crisis to become relevant. Returns may be disappointing, because it takes years for earnings to catch up to prices, because multiples shrink, or because better possibilities finally appear elsewhere.
Buffett has been banking those same moments for decades.
This is a market that may go higher from here. But with his famed valuation metric more than 40 percentage points above the threshold he previously deemed “playing with fire,” investors are paying a price Buffett once thought remarkable.
And Berkshire still has $359 billion on the sidelines for something better.
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