Warren Buffett’s favorite indicator says stocks are overpriced: Here’s what actually may be going on

So far this year, the U.S. stock market, as measured by the S&P 500, has returned about 10% — an average year’s worth of gains in just over three months. After any first-quarter run-up, two brands of market-watchers tend to appear in headlines: those who think stocks can continue to ascend and those who warn that a bubble may be about to pop. The latest rumbling from the latter camp have pointed out that stocks look overvalued by the standards of none other than Warren Buffett. The so-called Buffett indicator compares the total market capitalization (share prices times outstanding shares) of all U.S. stocks with the quarterly output of the U.S. economy. Things are in normal territory if the total value of the Wilshire 5000 index (which measures the total market) is about on par with the latest quarterly GDP estimate. If stocks are at about 70% of GDP, they’re said to be undervalued. Stocks trading at about double the size of the economy is considered a major red flag. As of late, the ratio is at about 190% — the highest mark in two years. In calendar year 2022, the last time stocks traded in this territory, the S&P 500 dropped 18%. So is it time to brace for impact? Not quite yet, says Liz Young, head of investment strategy at SoFi. “If we’re comparing a bubble to the late 90s and early 2000s, no, this is not a bubble,” she says. “We’re in extended valuations, but we’re not outrageous, we’re not off the charts.”

A ‘comforting’ situation for stocks

Stick around in markets long enough, and you’ll eventually see a bubble pop. This occurs when investors bid up the price of an asset to the point where valuations become untethered from historical norms and underlying fundamentals. When everyone realizes that they’ve gotten out over their skis, they begin to take profits, prices fall, panic sets in and the asset falls rapidly in value. Buffett’s favorite indicator is a blinking light to investors that stocks are in shaky territory compared with historical norms. But dig into what’s been driving stocks, and you’ll find that the current run isn’t just a product of investor enthusiasm. “The equity market rally that we’ve seen so far has been driven by earnings growth,” says Gargi Chaudhuri, chief investment and portfolio strategist, Americas, at BlackRock. “If this earnings growth wasn’t taking place, I may have been more open to acknowledging the bubble concept.” In short, stocks are doing well because their underlying companies — particularly large, high-quality tech companies – are boosting their profits. “The most profitable names are doing very well. They’re not speculative,” Chaudhuri says. “The fact that earnings growth continues to be what’s fueling returns is pretty comforting to me and should be to investors as well.”

Expect some bumpiness

In many regards, the picture for the economy is rosy, too. “GDP growth remains strong, the consumer continues to spend and earnings growth as been healthy and above expectations,” says Young. “The labor market has stayed strong and inflation has maybe plateaued, but not entirely gone back up again yet. I think that’s the fundamental bull case.” Nevertheless, she sees some cracks in the economic façade. While the factors above would indicate that the economy is in the middle of a bull cycle, Young says other indicators are making it look like it’s closer to the end. The longest-ever inversion of the yield curve and a marked uptick in gold prices would both seem to indicate that some pockets of investors are losing confidence in the economy, for instance. The Fed is performing a tricky tight-rope walk as it plans to slash interest rates this year without retriggering inflation worries, Young says. “Go back to any recession or economic retraction, and you’ll find headlines about the Fed pulling off a soft landing,” she says. Chaudhuri’s stock market outlook for the remainder of the year skews more bullish, but she says investors shouldn’t expect up-and-to-the-right performance over the next nine months. “We’ve seen several weeks of incredible performance. Can we have moments and periods in the equity markets where we get a pullback? Absolutely,” she says. “By no means am I trying to say it’s up and up and up from here.” Nevertheless, Chaudhuri says diversified stock portfolios will continue to benefit from a growth in corporate earnings and U.S. economic output. With interest rates expected to remain relatively high, investors would be wise to focus on highly profitable companies with little debt, she adds. “The names that are doing well are the names that are the very highest quality, most profitable companies.”