Warren Buffett Indicator Predicts Stock Market Crash in 2019
Investors beware, the Warren Buffett indicator suggests a stock market crash could be ahead for 2019. We could see immense losses on key stock indices, meaning your portfolio could get hit badly if you are not careful.
You might be wondering why there is such a bearish outlook on the stock market in 2019.Well, it’s not based on a gut feeling. Rather, it’s based on a very powerful indicator that famed investor Warren Buffett uses; that’s why it’s named after him. In case you didn’t know, Buffett has made a fortune by investing in the stock market, with a net worth north of $80.0 billion. In other words watching the indicator could be very beneficial.
What is the Warren Buffett Indicator?
The “Warren Buffett indicator” is less mysterious than it sounds. It might as well be called the “common sense indicator.”
At its core, the Warren Buffett indicator is the relationship between gross domestic product (GDP), or the sum total of a country’s economic activity, and the value of stocks in the S&P 500. Put simply, it measures stock market capitalization versus the U.S. GDP.
It’s actually very easy to understand.
When this ratio is around 60%-75%, it means the stock market is undervalued. This sort of scenario happens when the U.S. economy is going through an extreme downturn and stock markets have crashed.
In the midst of the stock market crash of 2008-2009, this ratio dropped to around 60%. At that time, the Warren Buffett indicator predicted that it was a great buying opportunity. Those who acted based on this prediction enjoyed heft gains.
When the Warren Buffett indicator is around 95%-100%, then valuations are fair.
If this ratio goes above 115%, it means overvaluations are common. When this happens, it would be wise for investors to focus on capital preservation rather than being complacent.
In March 2000, the indicator reached 148%. That was a period of extreme euphoria for the stock market. However, if you got excited and bought at the time, then just a few months later, your portfolio would have suffered massive losses.
In June 2007, this ratio reached over 110%. At that time, we saw a major top form on key stock indices. A stock market crash followed a year later.
In other words, the Warren Buffett indicator works like a barometer. And when it predicts rain, you had best keep an umbrella handy.
What is the Warren Buffett Indicator Saying Now?
Keep in mind that Warren Buffett has not said anything specific to the effect of “the stock market will crash in 2019.”
Buffett tends to make longer-term analyses rather than short-term predictions. For example, his latest major prediction is that the Dow Jones Industrial Average could hit 1,000,000 points in 2118. That’s well over 40 times the current number.
But, if you look at the indicators Buffett follows, you could get some idea of how he’s looking at things and where the stock markets could go in the short term.
Right now, the Warren Buffett indicator stands at 136.2%. That’s high—very high, well beyond “terminal velocity.” (Source: “Buffett Indicator: Where Are We with Market Valuations?” GuruFocus, last accessed March 11, 2019.)
Warren Buffett is famous for saying, “Be greedy when others are fearful and fearful when others are greedy.” The indicator he closely follows says investors are greedy and markets are overvalued, so be very fearful indeed. This is no time for the wise to be betting their savings in the stock market. (Source: “Warren Buffett’s big bank score proves his saying true once again: ‘Be greedy when others are fearful,’” CNBC, June 30, 2017.)
Other Factors in Line with the Warren Buffett Indicator
The Warren Buffett indicator suggests a sell-off could be ahead in 2019, and a lot of data backs this argument.
For example, we see the global economy turning. Major economic hubs are reporting dismal data. The stock market’s performance is highly dependent on global economic performance; if there’s a widespread global slowdown, it could spook investors, potentially causing them to sell.
Beyond this, the most important factor for a stock market rally is earnings facing headwinds. If earnings fall, stock markets fall.
For the first quarter of 2019, 76 S&P 500 companies have issued negative guidance about their earnings, while just 27 have issued positive guidance. That’s a three-to-one ratio of negative-to-positive guidance.
Even Wall Street analysts are becoming pessimistic. Over the past few years, they have been upbeat about earnings. But for the first quarter of 2019, they expected the S&P 500 to register a decline of 3.4% in earnings. (Source: “Earnings Insight,” FactSet, March 8, 2019.) Analysts expect growth of 0.2% in the second quarter, 1.7% in the third quarter, and 8.1% in the fourth quarter. Keep in mind that analysts tend to revise their earnings estimates lower, so it wouldn’t be shocking to see them lower their estimates in the coming months.
Looking from a valuation perspective, the markets are overvalued.
Consider the cyclically adjusted price-to-earnings (CAPE) ratio, which is the price-to-earnings ratio adjusted for inflation and cyclicality.
At the time of this writing, the CAPE ratio stands at around 30. (Source: “Online Data Robert Shiller,” Yale University, last accessed March 11, 2019.)
The number 32.11 by itself doesn’t really mean much, but look at it from a historical perspective. The historical average of the CAPE ratio since 1881 is 16.8. That means this valuation measure is suggesting that the stock market is currently trading about 80% above its historical average.
How Low Could the Stock Market Go?
Since the great recession, we have seen investors rush to buy stocks because yields weren’t that attractive elsewhere.
Over the past few years, we have seen a lot of euphoria. Euphoria never ends well. Investors have just simply rushed to buy stocks because they were going higher. Very little importance was given to valuations.
If the Warren Buffett indicator is correct, we could see a rigorous pullback on the stock market. The chart below plots the S&P 500 over the long term:
Chart Courtesy of StockCharts.com
Once the stock market starts falling, it doesn’t really stop until it reaches the previous support level.
For example, in the stock market crash of 2008-2009, the S&P 500 didn’t really stop falling until the major support level that was formed in 2002.
This time around, losses could be of a similar magnitude, if not greater.
Over the past few years, the market has run up so high falling back to the previous support level could result in major losses.
For the S&P 500, the next support level isn’t until 2,175; that’s roughly 22% below where it currently stands. But don’t forget that that’s not a major support level.
The next major support level isn’t until 1,575. If the S&P 500 falls to that level, it would mean a decline of 43%.
What to Do if There’s a Stock Market Crash in 2019
The Warren Buffett indicator is saying that losses could be ahead in 2019 and beyond.
The best investment strategy at the current moment would be to focus on capital preservation rather than actively buying stocks. It might not even be a bad idea to sell losing positions in the rally we are seeing. If your position hasn’t done well in the greatest bull market in history, chances are it won’t do well in the coming years either. Mind you, selling a losing position would raise cash for your portfolio. In case there’s a sell-off, investors could use that cash to buy great opportunities at discounted prices.
Another capital preservation strategy would be to place a stop-loss on positions that have greatly increased in value over the past few years. Stop-losses are like insurance policies on portfolio and save investors from massive losses.
The last thing investors could do if there’s a sell-off is give away their gains.
At the very least, don’t get too complacent.
For those who want to speculate and take above-average risk consider exchange-traded funds (ETFs) like the ProShares Short S&P500 (NYSEARCA:SH). This ETF increases in value as the S&P 500 declines. However, note that this is not a buy recommendation, but just an example of what investors could do, and that holding this ETF carries a lot of risk.