Legendary investor Warren Buffett has previously referenced the “Buffett Indicator” as his favorite metric for a general overview of the optimism or pessimism priced into equity markets. The Buffett Indicator measures the size of the U.S. stock market against the size of the economy by taking the total value of all publicly traded companies (measured using the Wilshire 5000 index) and dividing that by the last quarterly estimate of gross domestic product. Buffett says that a reading of 100% is fair, if it’s closer to 70%, stocks are at a bargain price, and if it is close to 200%, that could very well be a bubble. The current valuation is near 190%, which is a two-year high and consistent with levels where we have seen previous bubbles pop.
The question is, what narrative is driving this market and valuation surge? Euphoria surrounding artificial intelligence (AI) seems to be the primary culprit, as stocks such as Nvidia and ARM explode to record levels. That rally has broadened a bit as cyclicals and financials have had a strong rally too, from much lower initial valuations. Semiconductors have seen a doubling of their PE, but even these other sectors have seen their multiples expand from 30-70% on average. What’s bizarre about the AI phenomenon is that stocks seem to get a huge benefit from any association, but few stocks seem to be seen as losers on the technology innovation. I’m not sure how that would work in reality. For instance, let’s say Chat GPT begins to dominate Search. Wouldn’t that hurt Google, who of course has their own AI tools? When Amazon became a dominant retailer, department stores and malls took the biggest hit, but the market is acting liking everyone is going to be a winner, speaking to the optimistic expectations priced into stocks. The reality is that valuations have simply expanded to worrisome levels.
It is times like these where financial advisors field questions such as why don’t we own 100% stocks? Risk tolerances are always high until actual volatility occurs. We don’t want to just bet that the roulette wheel will keep coming up on black each spin, when the first occurrence of red could greatly jeopardize your retirement plan. We are risk managers, and our job is to best position your assets to meet your financial goals and objectives, within your true risk tolerance. Sadly, many retirees are getting way too aggressive chasing performance and history has shown time and time again how this story ends. Meanwhile, we are able to scoop up high-quality bonds at high single-digit yields, with the potential to produce double-digit returns per when yields drop.
One of the most attractive sectors currently is commercial real estate outside of the very troubled Office space. Concerns over the short-term higher interest rate environment has caused many of these companies to see their valuations decline by 40-50%, despite growing cash flows and dividends. These assets will produce prodigious cash flows and dividends for decades to come, so focusing too heavily on the next 6-12 months is the type of short-sighted myopia that value investors like us are able to exploit to our advantage. We own a variety of the best publicly traded REITs that we believe can offer 50-75% upside, along with paying us 6-8% dividends while we wait.
Please keep in mind that market bubbles hurt the most aggressive at the last stages of the bubble the hardest. You don’t want to chase past performance when the risks greatly outweigh the rewards. Think of how great of a position we will be in when the bubble pops and our assets are protected, with the opportunity to fully take advantage of the bargains that exist. I absolutely could see us locking-in profits on many of our bonds and then reallocating towards deeply undervalued equities when the odds are stacked in our favor.
Here is a link to all of our most recent radio shows where we have been covering a wide variety of financial planning topics each week: Radio Shows
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