Watch the “Buffett Indicator” for Clues to the Stock Market’s Next Move

The stock market, as a “weighing machine” (to quote Benjamin Graham), appears to be broken. Even with the coronavirus devastating nearly every sector of the economy, the disconnect between the economy and the equities market remains wide and persistent.

Realists will understand that central-bank intervention is what’s allowed this phenomenon to exist for so long. We could also blame corporate stock-share buybacks, but that pillar of history’s longest-ever bull market may be taken away soon.

This is where Berkshire Hathaway CEO Warren Buffett, sometimes considered the world’s greatest living investor, can provide clarity and guidance. Buffett’s not much of a technical trader; rather, his outlook on stocks depends on fundamentals, productivity, and profitability.

As we enter into the month of May, the old stock-market adage “Sell in May and go away” is on the lips and minds of concerned investors. For the time being, is it better just to avoid buying index funds? Or should we trust the Federal Reserve and buy the Dow/Nasdaq/S&P regardless of conventional wisdom?

There’s something to be said for conventional wisdom as time-honored principles have made Warren Buffett a very wealthy man. Nobody’s perfect, but Buffett’s practical wisdom has allowed him to accurately gauge the market even while complacency pervades the trading community.

And what Buffett sees now is an economy in deep contraction mode, help up by a small handful of high-flying tech names. He sees 26 million new unemployment claims within five weeks, supply chains choked, airplanes grounded, and malls closed.

Courtesy: U.S. Bureau of Economics

He also sees the real U.S. gross domestic product (GDP) in free fall after decades of steady growth. This crucial metric cratered 4.8% during the first quarter of 2020, signifying an astonishing drop in America’s economic output.

And keep in mind that the 4.8% drop doesn’t fully measure the extent of the coronavirus’s fiscal damage. That last bar on the chart includes January, February, and March. The coronavirus’s impact wasn’t felt on a large scale in America in January and part of February.

When the next quarterly bar on the chart is printed, it should include April, May, and June. Only then will the financial toll of the coronavirus be better understood and appreciated. That’s about the time when the unemployment numbers will also start to be more reflective of the “new normal.”

A number of financial experts are trying to warn investors that the other shoe is about to drop. Referring to the short-term stock-market bottom formed in mid-March, DoubleLine CEO Jeffrey Gundlach commented, “I’m certainly in the camp that we are not out of the woods. I think a retest of the low is very plausible… I think we’d take out the low.”

Meanwhile, Bank of America’s Michelle Meyer warns, “This will be the deepest recession on record, nearly five times more severe than the post-war average,” and JPMorgan economists expect that the nation’s annualized real GDP will contract by 40% during the current quarter.

Courtesy: Business Insider

And then there’s the “Buffett indicator,” which is Warren Buffett described as “probably the best single measure of where valuations stand at any given moment.” In a nutshell, it’s the market cap of the American stock market divided by the nation’s GDP.

When the stock market is too expensive compared to what the country is actually producing, the indicator gets stretched to the upside. It’s surprisingly accurate as the indicator hit 118% immediately prior to the dot-com bubble burst that happened back in the year 2000.

The indicator also exceeded 100% right before the financial crisis of 2008. Just a cursory glance at the chart above should give you an idea of how overextended the indicator has become in recent year. In fact, it’s at its highest reading ever recorded and has never been anywhere near the current level.

One logical conclusion from all this is that the major stock-market indexes are grossly overvalued. Another takeaway is that when the inevitable snapback occurs, it will be fierce and devastating to unprepared investors.

So you can either believe time-tested metrics, or you can believe the Federal Reserve and the corporate media. It’s entirely your choice, but today I’m siding with the Oracle of Omaha as his wise eyes see nothing but trouble ahead.