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:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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“.

Should you invest £1,000 in JD Sports right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if JD Sports made the list?

See the 6 stocks

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.

We think earning passive income has never been easier

Do you like the idea of dividend income?

The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…

Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.

What’s more, today we’re giving away one of these stock picks, absolutely free!

Get your free passive income stock pick

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

£20K invested in Tesla stock last April is now worth…

Despite all the bad headlines lately, Tesla stock has put in a storming performance over a 12-month timeframe. Is this…

Read more »

Investing Articles

If a 40 year old invests £600 a month in a SIPP, here’s what they could have by retirement

With no retirement savings at 40, an investor could put £600 a month into a SIPP and grow its value…

Read more »

Stack of British pound coins falling on list of share prices
Investing Articles

Why hasn’t its 9.9% yield boosted the Phoenix share price?

Phoenix Group has a dividend close to double digits, but saw a weak share price performance in recent years. Christopher…

Read more »

Silhouette of a bull standing on top of a landscape with the sun setting behind it
Investing Articles

With average 10% yields, these mid-cap FTSE shares could supercharge a passive income portfolio

Some of the best passive income gems can be found on the UK's smaller indexes like the FTSE 250 and…

Read more »

A coin being dropped into a piggy bank
Investing Articles

As the Barclays share price tanks 19% in 2 days, is this a great buying opportunity?

As a trade war sends the Barclays share price into a tailspin, Andrew Mackie steps back to look at the…

Read more »

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.
Investing Articles

Is Fundsmith Equity still a good choice for a Stocks and Shares ISA in 2025?

Many Britons hold the Fundsmith Equity fund in their Stocks and Shares ISAs. Is this still a good move? Edward…

Read more »

Investing Articles

Nvidia stock is down 24% this year. Time to buy the dip?

Christopher Ruane has been eyeing Nvidia stock as a potential addition to his portfolio for a while. Is a recent…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Down 25% since January, this resilient dividend stock’s catching my eye

Maintaining the UK’s rail, water, and energy infrastructure isn’t the most exciting business. But it has made this a solid…

Read more »