Buffett Indicator: Why Investors Are Walking Into A Trap

“The stock market is not the economy.” Such has been the “Siren’s Song” of investors over the last couple of years as valuation expansion has been the sole driver of the market’s performance. However, given that corporations derive their revenue from economic activity, the “Buffett Indicator” suggests investors may be walking into a trap.

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Buffett Indicator Investors, Buffett Indicator: Why Investors Are Walking Into A Trap

Understanding The Buffett Indicator

Many investors are quick to dismiss any measure of “valuation.” The reasoning is if there is not an immediate correlation, the indicator is wrong. As I discussed previously in “Shiller’s CAPE – Is It Just B.S.”

The problem is that valuation models are not, and were never meant to be, ‘market timing indicators.’ The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level it means that:

  1. The market is about to crash, and;
  2. Investors should be in 100% cash.

Such is incorrect. Valuation measures are simply just that – a measure of current valuation. More, importantly, when valuations are excessive, it is a better measure of ‘investor psychology’ and a manifestation of the ‘greater fool theory.'”