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Warren Buffett’s Top Indicator Shows Another Stock Market Crash Is Due

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After crashing sharply in March, stock markets rallied, as government stimulus packages were launched, seeing the Dow Jones Industrial Average climb 27% from its coronavirus low and the S&P/TSX Composite gain 23%. This has done little to allay fears of another stock market correction.

Preparing for a stock market crash

It appears that the world’s greatest investor Warren Buffett is anticipating another sharp market decline. Through Berkshire Hathaway, Buffett has built a massive war chest with its pile of cash swelling to a record US$133 billion by the end of the first quarter 2020. Buffett continues to dump stocks, recently selling his entire airline holdings, across the four major U.S. carriers, worth north of US$4 billion.

The Oracle of Omaha’s move to boost cash holdings has sparked considerable speculation that Buffett is anticipating another stock market crash. There are appreciable signs that the worst for the stock market has yet to pass.

Buffett’s preferred stock market indicator, which measures the stock market’s value as a ratio of gross domestic product (GDP), recently hit a record high. This suggests that a sharp market pullback is due.

How does the Buffett indicator work?

The indicator gauges the value of the stock market relative to U.S. GDP. It does this by dividing the total market cap by the latest quarterly GDP. Buffett claims it is the best measure of whether the stock market is overvalued. In a 2001 Fortune magazine article, he stated, “It is probably the best single measure of where valuations stand at any given moment”

After hitting an all-time high of 153% at the end of 2019, the ratio has pulled back to 133%. This is not only substantially higher than the long-term average but indicates that the U.S. stock market is heavily overvalued. This denotes that a stock market correction or worse is due.

The TSX is not as heavily overvalued as the U.S. stock market, as highlighted by a Buffett indicator of 107%, but this still illustrates that Canadian stocks are overvalued. If U.S. stocks plunge lower, then stock markets across the world will follow, because there is a strong correlation between U.S. financial markets and those around the world.

As the GDP declines, because of the economic fallout from the coronavirus, the ratio will continue to widen until there is a market crash.

Poor economic fundamentals

Several economic barometres indicate that there is worse ahead. The IMF expects 2020 U.S. GDP to shrink by almost 6%, while its forecast for Canada anticipates a 6.2% decline. Canada’s first-quarter 2020 GDP, according to Statistics Canada, plunged by 2.6%. There is worse head, because the economic fallout from the pandemic will only worsen over the remainder of the year.

Consumption and business activity are tipped to sharply deteriorate because of governments shuttering non-essential services, restricting movement, and closing borders. Those events indicate that there will be a marked decline in corporate earnings, which will spook markets further, as the reporting season gains momentum.

U.S. banks, which are a good indicator of overall economic health, reported significant first-quarter earnings declines. A similar outcome is expected for Canada’s banks. The national flag carrier Air Canada recently reported a whopping $1 billion first-quarter 2020 net loss.

Looking ahead

Sharply weaker commodity prices, notably oil, rising bankruptcies in industries directly impacted by the pandemic, and a sharp decline in consumption will weigh heavily on many companies as well as the broader market. That — along with a substantially weaker economy — will cause second- and third-quarter earnings to worsen as the full impact of the coronavirus is felt.

As poor earnings mount, they will weigh on market sentiment, triggering another stock market correction. This, many pundits believe, will cause the Dow and TSX to plunge below their March bottoms. It is for this reason that Buffett is selling stocks and bolstering his cash holdings.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Matt Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short June 2020 $205 calls on Berkshire Hathaway (B shares).

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