The Stock Market Is Triggering a Warning That Warren Buffett Calls “Playing With Fire.” Here’s What History Says Comes Next.
Over the past three years alone, the S&P 500 (^GSPC -0.48%) and Nasdaq Composite (^IXIC -0.64%) have surged by around 80% and 97%, respectively, as of this writing. But all of that growth makes this one of the most expensive markets in decades, and that’s not necessarily good news for investors.
Concerns around an artificial intelligence (AI) bubble are also on the rise, and some investors are drawing parallels to the dot-com bubble from the early 2000s. One of Warren Buffett’s dot-com-era warnings is more relevant than ever, and history suggests it’s time to brace for volatility.
Image source: The Motley Fool.
Investors may be “playing with fire”
In a 1999 speech republished as an essay for Fortune, Buffett warned investors that the stock market was likely due for a pullback. The dot-com boom had lifted the market to record-shattering heights, but Buffett emphasized that such growth would be unsustainable going forward.
He, of course, was correct in his prediction. The dot-com bubble officially burst in March 2000, leading to a bear market that would last more than two years.
In 2001, Fortune published a follow-up essay with Buffett, in which he discussed his go-to valuation metric — now nicknamed the Buffett indicator. This metric measures the ratio between the total value of U.S. stocks and GDP, and a higher percentage suggests that the broader market may be overvalued.
“For me, the message of that chart is this,” he said of the Buffett indicator. “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.”
As of this writing, the Buffett indicator is at its highest point in history at just over 237%.
What history says is coming next
If over a century of history proves anything, it’s that a bear market is coming eventually. It’s impossible for the market to continue climbing forever, and as valuations surge, stocks will need to correct themselves at some point.
Exactly when that bear market will begin is anyone’s guess. No stock market metric — even the Buffett indicator — can predict the onset of a downturn. That said, it’s wise to start preparing sooner rather than later, and the best move investors can make right now is to ensure they’re only investing in stocks with solid foundations.
Record-high valuations suggest many stocks are overvalued right now, and those investments carry the most risk heading into a bear market. The dot-com bubble proved this on a massive scale, as hundreds of high-flying tech stocks crashed and burned when the sector collapsed. Stock price alone can’t tell the whole story, and even stocks that appear to thrive in the short term may not survive a recession.
The “key to investing,” according to Buffett
In Buffett’s 1999 warning to investors, he outlined his key ingredient to long-term investing:
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow,” he said in the Fortune piece, “but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
With concerns around an AI bubble growing, this advice is perhaps more relevant than ever. Rather than focusing on how much this technology could transform society, the smartest investors are seeking out specific companies that have robust fundamentals and long-term growth potential.
A bear market will hit eventually, and not all stocks will pull through. But the investors who own a portfolio full of healthy stocks with durable competitive advantages will be the ones who win out.
