The Big Picture
Is the stock market due for a correction? Some think so. Goldman Sachs recently published a research note suggesting the stock market is at risk of a "setback in the summer" and shifted to a neutral stance for equities on a three-month horizon. It was pointed out in that same note, however, that the firm is still overweight equities for a 12-month horizon.
This notion of a summer setback, then, would be considered a tactical call.
The message between the lines is that one might want to think about trimming one's exposure to the equity market if one wants to avoid a setback this summer. That's a defensible view in light of how far the stock market -- and its mega-cap leaders -- has risen in a short amount of time.
There is another indicator out there, however, that also points to a higher risk of a correction, if not something more. That would be the Buffett Indicator.
Playing with Fire
What is the Buffett Indicator? It is the ratio of the Wilshire 5000 market capitalization to nominal GDP.
It is known as the Buffet Indicator because Warren Buffett (you might have heard of him) called attention to it as possibly the best single measure of valuation. He did this in an interview with Forbes Magazine in late 2001.
Mr. Buffett provided some added perspective on how to think of this ratio:
"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire."
Let's take a look now where the Buffet Indicator stands.
For the record, the Buffett Indicator is just shy of 200%. That is interesting because that is where it was in December 2021, or just before the swoon of 2022 that was precipitated by the Fed's aggressive tightening campaign.
It is double where it was just before the financial crisis and it is nearly 40% greater than where the ratio stood at the peak of the dot-com bubble.
We can imagine what Warren Buffett might be thinking these days about the market's valuation. If there was a thought bubble above his head, it might look something like this:
Note the trajectory of Berkshire Hathaway's cash position. It looks closely aligned with the Buffet Indicator, which is to say Berkshire Hathaway looks ready to strike opportunistically in the event of a valuation reset (much like it appeared to do in 2022).
A Nice Dividend
If nothing else, Berkshire Hathaway's massive cash position implies Mr. Buffett isn't looking to play with fire.
Given how far the stock market has run, some might contend that Berkshire Hathaway and Warren Buffett have gotten burned sitting on all that cash (and cash-like instruments). These people shouldn't forget that Apple (AAPL) is one of Berkshire Hathaway's largest public holdings or that T-bills and money market funds have offered a decent and mostly risk-free return.
The latest 13F filing in May showed Berkshire Hathaway trimmed its position in Apple to 789.37 million shares from 905.56 million shares. Apple pays a quarterly dividend of $0.25 per share, which equates to $1.00 per year. In other words, Berkshire Hathaway is in line to receive nearly $800 million in dividends alone from its Apple position.
To be sure, Warren Buffett has not gotten burned while the stock market has continued to snub its nose at the Buffett Indicator.
What It All Means
Markets can stay overbought longer than one might think. The reverse holds true in that they can remain oversold longer than one might think, too. The Buffett Indicator at this point, however, doesn't connote a market in an oversold position. It does suggest it is overbought and, more directly, overvalued.
It is just one indicator, however, so it shouldn't be taken in isolation as the be all-end all indicator for investment decisions. What the Buffett Indicator connotes is that valuation risk at the index level is greater now and that one needs to be more discerning in allocating money to the market, as well as to individual stocks.
The need for discernment is evident in Berkshire Hathaway's cash position running figuratively a step ahead of the stock market's run to record highs.
