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A simple market measure monitored by Warren Buffett says stocks may be overvalued

Warren Buffett
Paul Morigi | Fortune | Time Inc | Getty Images
Warren Buffett

In March of 2009, the S&P 500 bottomed at 666. Today it's trading near 2200, which equates to a 226 percent increase in the large-cap stock index over the last seven-and-a-half years. There is no question that this bull market has been strong and long-lasting. Over the past few months, some experts have argued the current trend is long in the tooth and that stock valuations (as measured by metrics, such as the Shiller P/E) are stretched.

There are others, however, who say stocks have room to run, particularly now with a Trump victory and a strong rotation into financials and other segments of the market, and that equities are the best alternative compared to other asset classes they compete with. Both arguments are compelling, so what's an investor to do?

Let's take a look at the current positioning and wisdom of Berkshire Hathaway chairman and CEO Warren Buffett, one of the best investors of all time, to get a sense of where the markets are and the value they offer.

A dent in die-hard optimism

First off, Buffett is a die-hard, long-term optimist on the U.S. economy and on stocks in general. It is very rare for Buffett to voice a less-than-optimistic view about the prospects for stocks in the long run. Case in point: When asked after Donald Trump's election — Buffett was a big Clinton supporter — how stocks would react, Buffett said that stocks will be higher in 10, 20 and 30 years. He said the performance of companies over time is what drives those stock returns, not necessarily who wins the race for the presidency. But Buffett has at various times warned investors about paying attention to the market's overall valuation.

Back in 2001, Buffett asserted that the ratio of market capitalization to gross national product (GNP) "is probably the best single measure of where valuations stand at any given moment." If the ratio is disproportionately high — that is, the market is valued way above the total goods and services of any economy — it's time to be wary of stocks. The rationale is that a country's economic output should somehow track the earnings of its companies (and therefore share value).

Buffett highlighted the fact that in the late 1990s to 2001 (during the dot-com bubble), "the ratio rose to an unprecedented level" and again escalated, leading up to the 2007 financial crisis. The following chart shows upward pressure in recent years as well.

(Source: AdvisorPerspectives.com)

Buffett admits that the ratio has "certain limitations in telling you what you need to know."

One such limitation could be the effect of overseas business operations on both market capitalization and GNP figures.

First, GNP represents the total value of products, services and people within a country's boundaries, whether by domestic or foreign businesses. Second, market value is a combination of both domestic and international businesses. Differences in financial reporting, accounting rules, regulations, customs and tax laws create potential complications with respect to available data.

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Here is a limitation Buffett did not mention but is important to our analysis. While Buffett specifically used GNP in his ratio, we are going to use GDP instead, because (1) it's more commonplace and easier for investors to find, and (2) GDP and GNP track very closely. The U.S. Bureau of Economic Analysis made the switch from GNP to GDP as its primary economic measure in 1991 and, in doing so, said the difference between the two measures was "little."

That said, the current market cap/GDP ratio of nearly 125 percent, resulting from paltry GDP growth (less than 3 percent), could be problematic if you subscribe to Buffett's mantra. The ratio is now the highest it has been (it was even a little higher in 2015) since the market went over a cliff in 2000, when the ratio had actually been 151 percent.

As stated in his essay, "For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up."

If the ratio gets too high, Buffett says you're "playing with fire."

Buffett's cash clue

How the market's current valuation plays into Buffett's thinking in the current environment is hard to know, and Buffett remains constructive on stocks in the long run. But one other observation is Berkshire's cash balance, which totaled $85 billion as of September 30, the highest level ever.

Berkshire generates $1.5 billion in cash per month, and Buffett may be having difficulty finding productive places to put that to work, according to an AP report. Berkshire recently took relatively small positions in a handful of airlines, including American Airlines, Delta and United Continental. But despite those new purchases, the high amount of cash could be a sign he is not finding tons of value in today's market.

Buffett has always been fully transparent on his view that declining stock prices — of fundamentally sound businesses — present enormous opportunity. In a 2008 article, columnist Jason Zweig recounted a comment Buffett made at that year's Berkshire annual meeting about what to do when stocks go down.

"There's no reason we should become fearful if a stock goes down. If a stock goes down 50 percent, I'd look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50 percent over the next month."

Buffett's ability to identify quality companies at attractive prices and hold them for a very long time has been key to his success. But I think there is another ingredient as well — that of being patient when the market isn't providing attractive valuations and using cash strategically to buy when everyone else is selling. As Alice Schroeder, author of the Buffett biography "Snowball," wrote, "He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price."

Strategic investors, therefore, would be wise to keep an eye on both the market cap/GDP ratio — or GNP, if they prefer — as well as Buffett's cash balances, and use these indicators as part of their ongoing long-term portfolio-management process.

By John Reese, co-founder at Validea Capital Management, which manages the Validea Market Legends ETF (VALX). The ETF uses computer models based on legendary investor strategies for stock selection, including a Warren Buffett model.

(This story has been updated to reflect the fact that Berkshire Hathaway generates $1.5 billion in cash per month.)