What is the Buffett Indicator Telling Us About the Stock Market?

After a wild January and February 2014 that saw the averages plunge then recover quickly, we wonder what’s in store for the rest of the year. The pundits and soothsayers have started to polish their crystal balls and peer into the future. Unlike the goldie locks scenario of 2013, this year is froth with challenges and uncertainty. At the end of last year we saw the US Federal Reserve start to taper their bond buying program. Then, Janet Yellen, the incoming Chairperson of the Federal Reserve, noted that she intends to continue tapering again this year. Of the $85 billion in purchases we now have it down to $65 billion per month. The stock market has been fueled to record highs in large part through the steady flow of funds from the Fed’s quantitative easing. Now with this source of revenue slowing drying up, the question on investor’s minds is will the market continue its push into new highs this year or will it stall out?

To answer this question Wall Street employs a battery of analysts and quants to plot a probably future for the market. Some of these tools are highly sophisticated and some are quite simple. Investor Warren Buffett has his own rule for determining whether a market is overbought or oversold. Simply stated he uses the ratio of Total Market Cap to GDP. His reading at present is 134%, clearly in overbought territory and places it in the 94th percentile. However, in a recent interview, he stated that even with this reading, he still can see the market moving higher. Other analysts use a slight variation of this ratio by using the Wilshire 5000 valuation to GDP. This reading is now at 116%. Some argue that using GDP may be misleading because our large multi national corporations derive 40% of their profits overseas and this is not counted in GDP. Instead they favor using Gross National Product (GNP) that is the total production by citizens in a country regardless of where the income came from. Nevertheless, using these indicators we see that the market is highly overbought.

Other forecasters use a sentiment indicator. At present only 16.5% of investors are bearish, dropping below 20%. Using a contraion philosophy, they contend that too many investors are bullish.

Other flash points include the amount of margin debt outstanding. At present that number is at a record $401.2 billion. This can be especially troublesome if the market sells off sharply and investors do not have the money to meet their margin calls and then are forced to liquidate their positions. This would add more selling pressure to the market.

Then we have the quants who use a variety of mathematical tools to predict market trends. Some use one indicator, while others combine several indicators to come up with a prediction. The most widely mentioned are the Price Earning Ratio (PE), Dividend Yield, Price to Sales Ratio and Price to Book ratio. Still other use the number of stocks above their 200 day moving average and the number of stocks above their 50 day moving average as a gauge of market strength.

One condition is clearly emerging. We are in overbought territory, yet the past has shown us that even overbought markets move higher. What we often see at these levels is sector rotation. While the averages move slightly higher, mutual fund managers and large investors move their money around the board more often. This is often difficult for the average investor to follow. It is probably best to analyze your portfolio and decide to place stop loss orders to protect your profits in case we get a nasty sell off.

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