In the December 10, 2001 issue of Fortune, Warren Buffett wrote a landmark 7-page article that introduced a crucial market metric that became renowned as the “Buffett Indicator.” The Great Man adapted the piece from a speech he’d given that July at the annual Allen & Co. bash in Sun Valley, privately delivered to the audience mainly comprising top CEOs. It was the legendary Fortune writer Carol Loomis who persuaded Buffett to adapt and extend his remarks for the article. Carol was my mentor during my early career at the magazine; I had the honor of working as her research assistant (no coasting allowed!) and she displayed the noblesse oblige to edit a couple of my pieces.
Even then, Carol had a great friend in Buffett. For many years, she famously edited the Berkshire Hathaway annual letter. I’m sure she’d admit that his guidance helped hone her forensic skills to the point where Carol could dissect the true financial performance of big enterprises from ITT to Hewlett-Packard to Fortune‘s owner Time Warner—she trashed the now-notorious AOL merger practically on announcement, irking our C-suite—better than practically any Wall Street sage or portfolio manager. At his last annual address as CEO in May of 2024, Buffett saluted Carol’s terrific work in helping the Oracle of Omaha rule as the most heeded voice in the business world, and correctly praised her “as the best business journalist.”
The concepts Buffett presented a quarter century ago are timeless, and they’re especially relevant today because the yardstick that he tagged as pointing to danger then, looks even more ominous now. Buffett was writing at a time when the Dot Com bubble was deflating. In the piece, he identified why the drop was inevitable, and likely to continue big time. His thesis: The total value of U.S. stocks, over the long term, can’t outpace the growth of businesses as reflected in the GDP, so when the ratio of S&P 500 to national income diverts hugely from the norm, it was bound swing the opposite way and “revert to the mean”—though the timing of the retracement is impossible to predict. Buffett highlighted a chart in the text displaying that at the craze’s peak in March of 2000, that number, now revered as the Buffett indicator, reached a vertiginous 200%.
“The message of the chart,” he wrote, “is that if the relationship [between the total value of equities and GDP] drops to 70% or 80%, buying stocks is likely to work out very well for you. If it approaches 200% as it did in 1999 and 2000, you are playing with fire.” Indeed, the S&P had already fallen over 20% by the time the Buffett story appeared, and by mid-2022 retreated by almost one half from its peak, taking the Buffett Indicator below 80%. As the Buffett formula predicted, the tech rampage’s aftermath proved a great moment to buy.
The Buffett Indicator is even worse than when he predicted disaster in 2001
Right now, the markets are riding a seldom-before-witnessed explosion in animal spirits. Since the decline prompted by the surprise start of the Iran war, the S&P 500 has rebounded over 13% to, as of mid-day on April 17, notch an all-time record of 7140. Here’s the shocker: The Buffett Indicator now stands at 232%, a figure that’s around one-sixth higher than what he identified as the prepare-for-a-roasting zone. A reading this elevated comes with two problems. First, corporate profits have been waxing much faster than GDP. The bulls claim that trend justifies today’s valuations, and that EPS can keep rolling in double-digits while national income trudges at a nominal 5% or so. The argument’s dubious: Profits are now 12% of GDP versus an historic average of 7% to 8%. In our highly competitive economy, fat margins attract competitors seeking a share of the action, so they push down prices and expand volumes to steal market share from the profit-rich incumbents. Extraordinary earnings growth generally doesn’t stay extraordinary. As the late Nobel-winning economist Milton Friedman told this writer, “Corporate earnings as a share of national income cannot rise beyond their historic share of GDP for long periods.”
Second, stocks have also gotten far more expensive relative to their profits. The S&P 500’s price-to-earnings ratio based on forecast Q1 GAAP net earnings exceeds 28. That’s two-thirds higher than the 100 year average of around 17. Best bet: Both profits and PEs trend back towards normal, taking the Buffett Indicator, and the S&P, downwards with them.
How bad could the drop be, based on the past instances of an astronomical Buffett indicator? Once again, the decline from the Dot Com driven 200% mark that prompted the Buffett piece was about half. In November of 2021, the Indicator reached just over that fearsome benchmark, then tumbled 19%.
In the Fortune article, Buffett warned that if investors expected shares to roar higher when his Indicator was hovering at those historic highs, “the line would have to go straight off of the chart,” meaning the optimists were banking on a suspension in economic gravity. Right now, the bulls are in charge, and they’re predicting the Buffett Indicator that’s already hit uncharted territory will push further into the “playing with fire” realm. My hero Carol Loomis provided a great service in persuading her pal to share what become justly honored as the Buffett Indicator with all of us. This evergreen measure has issued a warning on intoxication: Keep imbibing the happy talk, and you’re in for a long hangover.
