The Motley Fool

The Buffett Indicator: A Stock Market Crash Is Coming

Image source: Getty Images

On Monday, I wrote about Buffett’s third-quarter purchases and how they indicated a coming bull market in stocks. Today, I’m going to talk about another Buffett-related indicator that points in the opposite direction.

The Buffett Indicator is a famous ratio popularized by Warren Buffett during the dot-com bubble. The ratio is market cap to gross domestic product (GDP). In 2001, Buffett said, “It is probably the best single measure of where valuations stand at any given moment.” Today, the ratio is historically high, which is definitely not a good sign for stocks.

Where the Buffett indicator sits today

According to Advisor Perspectives, The Buffett Indicator currently sits at 181. That’s above the historical norm. Generally speaking, the higher the Buffett indicator, the worse the reading. That’s because a high Buffett indicator suggests overvaluation. When the Buffett indicator is high, stock prices aren’t justified by economic fundamentals. Over the long term, that tends to result in falling stock prices.

Where it could be headed

While the Buffett indicator is high now, it needn’t necessarily remain high until a stock market crash lowers it. An abrupt GDP spike could have the same effect. Currently, economic activity is artificially being kept down by forced business closures. Assuming the affected businesses are able to survive, they’ll get back to business when the forced closures end. That will result in a quick jump in GDP, as corporate earnings begin to swell.

The only question mark is how long the second wave of lockdowns will last. If it goes on for much longer, many businesses will have to close permanently. If that happens, a huge, dramatic GDP spike may not materialize.

A solid investment for an overheated market

If you’re worried that the current stock market is overheated, you may want to look into other investments — specifically, bonds. While government treasuries yield almost nothing now, corporate bonds are a different story. So a corporate bond play could be a great way to smooth out the volatility in your portfolio.

Consider the BMO Mid-Term U.S. IG Corporate Bond Index ETF (TSX:ZIC). It’s a Canadian ETF built on U.S. corporate bonds. At today’s prices, it yields about 3%. That’s much better than government bonds and GICs. If you invest $100,000 in ZIC, you’ll get about $3,000 back in annual income.

That’s frankly half decent for bonds these days. Interest rates are low across the board, and ZIC yields about the same as a good dividend stock. So its 3% yield is nothing to sneeze at.

By getting corporate bond ETFs like ZIC in your portfolio, you get substantial protection from stock market volatility. When the stock market crashes, you can sell a bit of your bond portfolio, and re-balance back into stocks. There’s even a specific portfolio rule called the 60/40 rule that says you should be in 60% stocks and 40% bonds at all times.

By selling part of your bond portfolio to get stocks back up to 60% after they’ve crashed, you increase your portfolio return — definitely a strategy worth looking into.

By the way, these stocks could make great investments too...

Just Released! 5 Stocks Under $49 (FREE REPORT)

Motley Fool Canada's market-beating team has just released a brand-new FREE report revealing 5 "dirt cheap" stocks that you can buy today for under $49 a share.
Our team thinks these 5 stocks are critically undervalued, but more importantly, could potentially make Canadian investors who act quickly a fortune.
Don't miss out! Simply click the link below to grab your free copy and discover all 5 of these stocks now.

Claim your FREE 5-stock report now!

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 Andrew Button has no position in any of the stocks mentioned.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss an important event.

Iain Butler and the Stock Advisor Canada team only publish their new “buy alerts” twice a month, and only to an exclusively small group.

This is your chance to get in early on what could prove to be very special investment advice.

Enter your email address below to get started now, and join the other thousands of Canadians who have already signed up for their chance to get the market-beating advice from Stock Advisor Canada.