Warren Buffett is the world’s most famous investor. When the Oracle (NYSE:ORCL) of Omaha, as he is known, provides advice on a potential market crash, investors pay attention.
What is the Warren Buffett Indicator? One on Warren Buffett’s favourite market indicators is widely watched by investors. The simple metric compares the total value of the stock market to the quarterly Gross Domestic Product (GDP) number.
When the ratio tops historic highs, the stock market appears overbought and could be headed for a major correction or another market crash.
The Buffett Indicator takes the value of the Wilshire 5000 total market index and divides it by the quarterly GDP numbers. The Willshire 5000 recently hit US$38.9 trillion. In its December 22nd report on third-quarter GDP, the Bureau or Economic Analysis (BEA) estimates that Q3 GDP was about US$21.17 trillion.
This puts the Buffett Indictor at 38.9/21.17 = 1.8375 or roughly 184%. That’s near the highest level in the past 20 years. Warren Buffett has said the ratio is “probably the best single measure of where valuations stand at any given moment.”
The Warren Buffett Indicator isn’t perfect, but the ratio did spike right before the dotcom bubble burst. The ratio also soared ahead of the financial crisis and stock market crash that created the Great Recession.
Is a market crash coming in 2021? Pundits have different views on the outlook for the stock market next year. Valuations are certainly high. The S&P 500 price-to-earnings (P/E) ratio has historically run around 16.5 times. The market’s current level puts the S&P 500 around 22 times anticipated 2021 earnings.
Low interest rates play a role in stock valuations. The current low-rate environment is expected to continue. This tends to be supportive of higher stock prices, as more investors turn to dividend stocks and growth stocks in search of returns. As a result, analysts are more comfortable with the S&P trading above long-term average P/E ratio.
Nonetheless, the stock market appears quite overvalued based on historical patterns and averages.
Unemployment remains an issue and many countries continue to see COVID-19 numbers hitting new highs. Strict lockdowns in developed economies could delay the economic recovery and dent anticipated corporate earnings next year.
As such, investors might see a meaningful market correction in the near term. Whether a full-blown crash might occur is anyone’s guess. Normally there would have to be a significant event to induce a sell-off like we saw in March 2020. If a crash occurs, Warren Buffett will be ready.
Top Warren Buffett stocks to buy on a market crash A market crash is scary, but Warren Buffett has made significant money buying oversold stocks during times of market chaos. Another of his popular quotes advises people to “be greedy when others are fearful, and be fearful when others are greedy.”
In the current environment, it makes sense to look for opportunities to buy industry leaders with strong track records of dividend growth supported by rising earnings.
For example, Canadian National Railway might be a good stock to put on your radar. CN serves a key role in the efficient operations of the Canadian and U.S. economies. The company is the only railway with lines that connect ports on three coasts.
CN generates strong free cash flow and has one of the best compound annual dividend-growth rates in the TSX Index over the past 20 years. The stock normally bounces back quickly after a market crash, as we saw earlier this year.
Warren Buffett’s company Berkshire Hathaway (NYSE:BRKa) owns BNSF, a railway in the United States. His friend, Bill Gates, owns about 14% of CN’s total outstanding common shares.
The bottom line Another market crash is not guaranteed in 2021, but investors should keep some powder dry in case we get a major correction. Warren Buffett is right more often than wrong, and it makes sense to heed his advice.
Some stocks still appear fairly valued in the market today and could become great buys on the next downturn.
The post Warren Buffett: This Key Indicator Could Signal a 2021 Market Crash appeared first on The Motley Fool Canada.
David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Canadian National Railway. The Motley Fool recommends Canadian National Railway and recommends the following options: short January 2021 $200 puts on Berkshire Hathaway (B shares) and long January 2021 $200 calls on Berkshire Hathaway (B shares). Fool contributor Andrew Walker has no position in any stock mentioned.
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