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If you follow Warren Buffett’s methodology, stocks are significantly overvalued

Warren Buffett
Adam Jeffery | CNBC
Warren Buffett

When I turned bearish in January 2016 I missed three critical elements that caused the S&P 500 to grind toward record highs. First, a sufficient number of other investors did not share my skepticism about the global economy. Second, I misjudged investor faith in central bankers. Third, I underestimated the continued global appetite for yield bearing stocks. However, in recent days a host of big money investors have been vocally bearish. Does this mean the herd is turning and that I may have just been early? Perhaps, but what are these investors seeing that has led them to embrace my skepticism? Risk versus reward.

Big money understands that investing is more about balancing risk and reward than about being "right." Investing is a game of probability, and since nobody has a crystal ball, the best we can all do is make educated guesses and place bets when the odds are in our favor. The odds may no longer be in equity investor's favor.

Warren Buffett is one of the biggest investors in the world and his preferred method for valuing the stock market is now suggesting that U.S. stocks are significantly overvalued. Buffett has stated that using Total Market Capitalization to GDP is "probably the best single measure of where valuations stand at any given moment." For those who want to dig deeper into this valuation metric the website Gurufocus.com is a great resource.

Currently, the ratio of Total Market Cap (as measured by the Wilshire Total Market Index) to GDP is 121 percent. There is only one other time since 1971 that this ratio has registered such an overvalued reading…that was in December of 2000. Moreover, GuruFocus has tracked market returns using this indicator and at current levels it suggests the total expected yearly return for U.S. stocks is 0.1 percent, including dividends. The current dividend yield is roughly 2.04 percent, which means this indicator is forecasting that stocks will fall by 2 percent over the next year.

Think about that for a minute. The preferred valuation metric of the world's most successful and wealthiest investor is suggesting that there is little to no upside for stocks. When big money tries to calculate the risk of investing against the reward, a negative return will simply not compute. To my mind, this could be the reason that the likes of high-profile investors Jeff Gundlach and Bill Gross have suggested either selling everything or buying gold.

In addition to the lack of reward, faith in the ability of central bankers to manufacture an economic recovery is being challenged. Over the last few trading sessions the yield on Japanese government bonds have jumped the most since 2013. In the aftermath of the 2013 Japanese yield spike the Japanese stock market fell more than 7 percent

Will history repeat?

Japan has been the laboratory for experimental monetary policy for the better part of 20 years. Recently the head of the Bank of Japancalled for a review of current policy to be released in September. The market reaction to this anticipated review has been decidedly negative. The implication is that investors fear the Bank of Japan will admit defeat and no longer engage in market manipulation. I personally have my doubts that it will abandon its policies, but the crisis of faith is catalyst enough for investors to sell. Yet another reason big money is turning bearish.

Finally, the search for yield is showing signs of coming to an end. Since the February 2016 market lows, the iShares Select Dividend ETF(DVY) is up 17.5 percent, but interestingly the lower yielding Spyders ETF (SPY) is up 18.23 percent. To be sure the outperformance of the lower yielding SPY is a recent phenomenon, but cracks in the foundation are appearing.

Big money is turning bearish because the reward does not justify the risk. The market cap of U.S. stocks has far exceeded the value of GDP, typically a sign of negative stock market returns. The recent spike in Japanese yields has shaken investor faith in omnipotent central bankers, while the horn is blowing "Going Home" on the hunt for yield.

For a few weeks in February my bearish view was accurate, but the fullness of time has proved I miscalculated the skepticism of others, the faith in central bankers and when the hunt for yield would end. Perhaps the recent growls from prominent investors is a signal that the herd is turning, but the truth is only time can tell. What is clear to me is that the risk of owning stocks is simply not justified by the reward. I continue to remain defensive on U.S. equities and share the bullish view on gold.

Brian Kelly is founder and managing member of Brian Kelly Capital LLC, a global macro investment firm catering to high net worth individuals, family offices and institutions. He is also the creator of the BKCM Indexes, benchmarks for multi-asset money managers. He's also the author of the "The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World." Kelly, a CNBC contributor, often appears on "Fast Money." Follow him on Twitter @BKBrianKelly.

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