This Stock Market Metric Reached an Alarming New Record. Here’s What Warren Buffett Says Could Come Next.

The S&P 500 index (^GSPC +0.22%) just reached a new all-time high, soaring by more than 30% over the last 12 months, as of this writing. However, investors are not necessarily feeling encouraged by all of this growth. The University of Michigan’s Index of Consumer Sentiment reached a new low this month, falling below its previous low in 2022.

More investors are feeling pessimistic than optimistic, according to the most recent weekly survey from the American Association of Individual Investors. While around 32% of survey participants believe stock prices will rise in the next six months, close to 44% believe they’ll fall.

Major market indicators are also reaching potentially concerning new levels. Here’s Warren Buffett’s advice on what might be coming next.

Image source: The Motley Fool.

The Buffett indicator is sounding the alarm

The Buffett indicator compares U.S. GDP and the total value of U.S. stocks, and it earned its nickname after Warren Buffett used the metric to correctly predict the onset of the dot-com bubble burst in the early 2000s.

A higher ratio suggests that the market could be overvalued, and according to Buffett, it also means investors should exercise caution.

“If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you,” he explained in a 2001 interview with Fortune Magazine. “If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.”

The Buffett indicator has been gradually creeping upward since the end of the Great Recession, but this month, it reached a new all-time high of around 231%.

Should you stop investing right now?

Company valuations have surged with the rise of the tech industry, so it’s normal for this metric to creep higher over time. The Buffett indicator has consistently hovered above 200% since July of last year, and it hasn’t been below 100% since 2013.

In other words, as the market landscape changes, Buffett’s 200% benchmark may be more of a guideline than a hard-and-fast rule. It doesn’t necessarily suggest that a recession is around the corner, but because the metric is significantly elevated, it may be wise to choose your investments carefully right now.

To be clear, this doesn’t mean you should stop investing entirely or pull your money out of the market. Stocks have proven incredibly resilient over the last year despite numerous economic challenges, and the market could have many more months of growth ahead. If you quit investing now, you could miss out on potentially lucrative gains.

Rather than avoiding the market, it’s wise to invest in quality companies with solid fundamentals. There are still plenty of undervalued stocks with long-term growth potential, and even if a downturn is on the horizon, these stocks are likely to thrive over time despite short-term volatility.