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.

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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“.

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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.

Created with Highcharts 11.4.3British American Tobacco P.l.c. PriceZoom1M3M6MYTD1Y5Y10YALL10 Jul 201910 Jul 2024Zoom ▾Jan '20Jul '20Jan '21Jul '21Jan '22Jul '22Jan '23Jul '23Jan '24Jul '242020202020212021202220222023202320242024www.fool.co.uk

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.

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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.

Like buying £1 for 51p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this recent ‘Best Buy Now’ has a price/book ratio of 0.51. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 51p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 8.5%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

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