A stock market correction may be near, warns this Warren Buffett metric

A famous Warren Buffett valuation indicator just flashed a silent warning to investors, suggesting the market may be dangerously overheated.

| More on:
Three signposts pointing in different directions, with 'Buy' 'Sell' and 'Hold' on

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Both the S&P 500 and Nasdaq Composite indexes reached new all-time highs yesterday (9 July). While that’s undoubtedly great news for Warren Buffett’s massive Berkshire Hathaway stock portfolio, it also brings a more concerning valuation indicator into focus.

In fact, this metric is now at a record high, potentially serving as a red flag investors.

The ‘Buffett Indicator’

Back in 2001, Warren Buffett revealed what he considered to be “probably the best single measure of where valuations stand at any given moment“.

This valuation metric, now commonly known as the ‘Buffett Indicator’, divides the total market capitalisation of a country’s stock market by its annual gross domestic product (GDP). It tries to roughly gauge whether the market is overvalued or undervalued.

A high market cap-to-GDP ratio (over 100%) suggests that stocks are overpriced relative to the economy, signalling potential risk. A disconnect between economic reality and share prices, essentially.

Today, this ratio stands close to 200%. That’s well above the 159% seen just before the dot-com bubble!

Going on this then, it might be very risky to start ploughing money into US stocks today. Perhaps that’s why Buffett’s Berkshire has been a net seller of stocks for six consecutive quarters.

Some nuance is needed

Now, I should point out some caveats here. The first is that no metric is perfect in isolation. Indeed, while many market watchers still follow the indicator carrying his name, Buffett has actually backed away from it.

One problem is that most large companies generate significant profits from international markets, making GDP potentially less relevant.

Moreover, while Buffett and his investing team may sell or trim positions, they don’t offload all their stocks completely. Berkshire’s ideal holding period for a stock remains “forever“.

Finally, the Buffett-inspired metric highlighted here relates to shares listed across the pond. It doesn’t apply to most UK stocks, which continue to look cheap by historical standards.

How I’m responding

Right now, I’m focused on beefing up other areas of my portfolio where I see more value. One is in FTSE dividend stocks, many of which continue to carry huge yields.

A great example is British American Tobacco (LSE: BATS), a stock I’ve been scooping up recently.

This is one of the world’s largest cigarette firms and owns brands like Dunhill and Lucky Strike, as well as leading vaping brand Vuse.

The headline attraction with the stock is its mammoth 9.4% dividend yield. If forecasts prove correct, this rises to nearly 10% by 2026. That would be nearly £100 back in dividends from every £1,000 I invest!

Now, forecasts don’t always prove correct and dividends are never guaranteed. And one reason the yield is so high is due to declining cigarette sales, particularly in the US. This remains a real risk.

However, to counter this, British American Tobacco is raising prices to keep profit margins (and dividends) fat. More importantly, it’s building up its non-cigarette unit, which includes vapes and tobacco pouches.

These products now make up around 12.5% of revenue and the division achieved profitability in 2023, two years ahead of schedule.

Finally, the low forward price-to-earnings (P/E) ratio of 6.8 appears to offer a decent margin of safety. It’s a 58% discount to US rival Philip Morris International.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Ben McPoland has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

Down 23%! Should I buy more CrowdStrike shares for my Stocks and Shares ISA?

Sometimes bad news can be good news for long-term investors. But is that the case for CrowdStrike in relation to…

Read more »

Investing Articles

2 UK shares near 52-week lows I’m considering snapping up

These UK shares are loitering near, or at, 52-week lows. Are these prime opportunities for our writer to boost her…

Read more »

Investing Articles

Unilever: a passive income stock with potential for decades of dividend growth

Stephen Wright thinks Unilever can keep reducing its share count for years to come. And this should help make it…

Read more »

Middle-aged black male working at home desk
Investing Articles

Worried about retirement? I’d buy high-yield dividend shares to build wealth

The number of pensioners enduring poverty in the UK looks set to rise. Investing in dividend shares could help Britons…

Read more »

Investing For Beginners

2 boring but beautiful FTSE 100 stocks to add to my ISA

Jon Smith runs over a couple of FTSE 100 stocks that he really likes the look of, even though they…

Read more »

Investing Articles

Here’s how I could supercharge my wealth by snapping up the best dividend stocks!

This Fool explains how dividend stocks play a crucial part of her aspirations to build wealth, and details one pick…

Read more »

Young female analyst working at her desk in the office
Investing Articles

Revenue up 10% and accelerated growth potential for this overlooked FTSE 250 company

Today's first-quarter update from this good-value FTSE 250 company keeps me keen on the stock as recovery and growth continues.

Read more »

Investing Articles

Here’s why I’m so bullish about the BT share price now

The BT share price shot up after FY results, and a couple of months on it's still up there. Might…

Read more »