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Few investors have more market experience than Berkshire Hathaway Inc (NYSE:BRK) (NYSE:BRK) CEO Warren Buffett, who's seen his fair share of over-extended bull markets. After the Dot-Com Bubble crash in 2000, Buffett noted that comparing the market capitalization of stocks to Gross Domestic Product (GDP) is the best indicator of whether equities are overvalued or undervalued at current prices.
Trouble Brewing? The indicator, dubbed as the ‘Warren Buffett Indicator' is calculated by looking at the ratio of the total market index compared to the GDP of the U.S. The total market index is tracked by the Wilshire 5000, which is a market-cap-weighted index tracking all U.S. publicly traded companies, comprised of more than 3,000 companies.
The Numbers: Currently, the Wilshire 5000 to GDP ratio sits around 195% according to Barchart, higher than the ratio preceding the dot-com bubble crash as well as the Great Financial Crisis in 2007-2008. In 2000, when internet stocks like Pets.com reached historically speculative levels, the Buffett indicator was around 140%. In 2007, ahead of the subprime mortgage crisis that wreaked havoc on the economy for years, the ratio was around 110%.
So: In today's market, higher interest rates have done little to dampen the valuations of large tech companies like Tesla Inc (NASDAQ:TSLA) or NVIDIA Corp (NASDAQ:NVDA), each trading with forward price-to-earnings rations above 50, well higher than the historical average for S&P 500 companies according to Macrotrends.
But, projections for earnings growth remains strong, indicating that while companies may look overvalued today, those multiples could come down to earth as earnings continue to grow. Ryan Detrick, chief market strategist at Carson Group, recently shared a chart on X showing that forward earnings expectations have steadily increased throughout the last few years, potentially helping explain why investors are willing to pay high premiums for stocks at current prices.
Will the ‘Buffett Indicator' predict another market crash due to high valuations compared to current GDP numbers? It will depend on if earnings continue to grow, thus driving GDP higher and bringing the Wilshire 5000 to GDP ratio closer to its historical averages.
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Image created using artificial intelligence via Midjourney.
