The ‘Buffett indicator’ signals a stock market crash is coming soon. Here’s how I would prepare for the situation.
What is the ‘Buffett indicator’?
Famous investor Warren Buffett’s favourite indicator US market valuation indicator divides the Wilshire 5000 Index by the US GDP. In other words, it compares the stock market to the country’s economic output. The economy – US and global – is under almost unprecedented pressure right now. At the same time, the US stock market has recovered.
Wilshire 5000 to GDP Ratio
If you look at the graph, you’ll notice that the indicator is much higher even than it was during the 2000 dotcom bubble. Investors obsessed with Internet commercialisation kept buying loss-making and overvalued companies. The bubble eventually burst.
But before that happened, Buffett, often referred to as the ‘Oracle of Omaha‘, warned his shareholders that a stock market crash was coming.
Here’s a quote from Buffett’s letter to his shareholders published back in 2000.
‘They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.’
This quote is highly relevant for today’s stock market frenzy, I think. The US market seems to be really overbought right now. The interesting fact is that 60% of the S&P 500 companies are down since the Covid-19 lockdown. But 40% of them, the so-called hi-tech corporations, have rallied to new highs. They currently trade at extremely high multipliers.
You might be wondering what it all has to do with UK investors. Well, when ‘the US sneezes, the whole world catches a cold’. It was the case with the Footsie back in the 2000s after the dotcom bubble burst. That situation might repeat itself.
Here’s how I’d prepare for the next stock market crash
I wouldn’t panic though. Instead, I’d follow Buffett and avoid spending all my cash at once. I’d also revise my portfolio holdings. Ideally, I’d get rid of the companies with poor balance sheets and low credit ratings. What’s more, I’d invest in companies that tend to flourish even during downturns.
They include, in my opinion, gold and silver miners. My colleague Matthew wrote a great article about firms specialising in extracting the yellow metal. Although Buffett has never favoured gold as a investment, he recently bought Barrick Gold‘s shares. The company is the largest miner in the world and pays dividends. In my view, UK investors also have many attractive alternatives to park their cash.
Apart from gold miners, I’d also think of undervalued companies producing or selling necessities. The most obvious sectors are the pharmaceutical industry and supermarket chains.