Warren Buffett's Preferred Valuation Metric Signals a Buying Opportunity

A crucial valuation criterion endorsed by renowned investor Warren Buffett indicates that equities are comparatively undervalued, reinforcing the argument that the robust recovery in US markets has further potential for growth.

Getty Image

The "Buffett Indicator" quantifies the ratio of the total valuation of the US stock market, as represented by the Wilshire 5000 Index, to the monetary value of US gross domestic product. It is at its lowest point since early September, despite a recent surge that has propelled markets far higher.

The 94-year-old CEO of Berkshire Hathaway, which will have its annual meeting in Omaha, Nebraska, this weekend, has stated that the "single best measure of where valuations stand" is the ratio of the value of US publicly traded companies to the nation's GDP. The indicator sent a warning late last year when it reached a historic high, reminiscent of similar indications observed before market peaks in 2021 and prior to the collapse of the dot-com bubble in 2000.

The metric currently stands at 180 percent, approximately the level it reached following the unwinding of the Japanese yen carry trade, which triggered a brief yet severe selloff last year. The stock market decline facilitated a significant rally in the S&P 500 Index over the latter months of 2024.

“This is a vital indicator as it assists traders in determining the optimal timing for capital deployment and stock acquisition,” stated Adam Sarhan, founder of 50 Park Investments, who has been investing heavily in Big Tech firms. “Concerns regarding the global trade war persist; however, if Trump refrains from imposing stringent tariffs, consumers are likely to engage in purchasing at significantly more reasonable valuations.”

This year, valuation indicators have gained more importance as investors assess whether a tariff-induced sell-off has rendered companies more affordable in relation to their fundamentals. The calculations are compounded by the S&P 500's 12 percent rebound from its April lows, prompting traders to contemplate whether to capitalize on momentum propelling the index upward or to enhance hedges and initiate bearish positions anticipating a decline. The index is almost 9 percent below its February peak.

Alongside the erratic developments of US President Donald Trump’s trade war, investors are preparing for additional weeks of earnings season and the forthcoming Federal Reserve meeting as potential catalysts that may influence stock trajectories.

The indicator remains elevated compared to the levels seen during previous market troughs, including the Covid-19 sell-off in early 2020, when it approached nearly 100 percent. Other frequently employed valuation metrics convey a same narrative: The S&P 500 currently stands at 20.6 times forecast earnings, reflecting an approximate 8 percent decline from earlier this year, yet remains above the 10-year average of 18.6 times.

Detractors of the Buffett indicator contend that, among other factors, the metric may overlook the impact of high interest rates. Increased borrowing rates can diminish corporate profitability and negatively impact stock values. Certain strategists assert that valuation is an inadequate instrument for timing market fluctuations, as assets may remain undervalued or overvalued for extended periods prior to adjustment.

Last month, the US corporation increased its investments in Japan's five largest trading houses, a move indicated in Buffett's annual letter to shareholders in February.

Nevertheless, few investors would overlook an investment praised by Buffett, renowned for acquiring assets at a low cost. Traders are keenly anticipating Berkshire's annual meeting on Saturday (May 3) to ascertain whether Buffett has utilized the company's cash reserves, recently reported at a record US$321 billion, to capitalize on market opportunities.

This may be one of Buffett's final meetings, since he informed shareholders in the company's annual letter earlier this year that a replacement, possibly Berkshire's Greg Abel, will assume the CEO position "before long."

Buffett "has consistently been a long-term investor," stated Scott Colyer, CEO of Advisors Asset Management. “It is essential to ascertain his perspective on the economy and whether lower valuations prompted him to allocate substantial cash towards stock purchases during the market decline.”