Warren Buffett Indicator Predicts Stock Market Crash in 2017 – Lombardi Letter

Warren Buffett Prediction on Stock Market in 2017

What are the top stock market predictions for 2017? When it comes to predicting the stock market, few are as accurate as Warren Buffett, the third-wealthiest person in the world, worth an estimated $60.8 billion.

In 2016, a year that saw the S&P 500 advance 10%, Warren Buffett added around $12.0 billion to his fortune. According to Bloomberg, Buffett’s wealth increased by 19% in 2016 to $74.1 billion. According to Forbes, Warren Buffett’s wealth increased by 20% to $74.2 billion. No matter how you look at it, Buffet was the biggest winner among America’s elite.

He’s always had a knack for making money too. Worth an estimated $6,000 when he was just 15 (1945), Buffett managed to build his wealth to over $60.0 billion by January 2017. This puts him just behind Microsoft Corporation’s (NASDAQ:MSFT) Bill Gates at $75.0 billion and Amanico Ortega with $67.0 billion to his name.

Over the last 53 years, Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A) stock has grown from a per-book share value of $19.00 to $239,930. Since 1964, his holding company has generated a 30% compound annual return for investors.

After such a stellar year, what is Warren Buffett’s stock market prediction for 2017? If actions speak louder than words, than the Oracle of Omaha does not have a lot faith in the stock market right now. Buffett’s stock market forecast may not be calling for an all-out crash, but every indicator suggests he’s waiting for a major correction.

Be Greedy When Others Are Fearful…

One of Warren Buffett’s greatest investing mantras is to “be greedy when others are fearful and fearful when others are greedy.” Never has more sound advice been given, especially in the early days of 2017.

2017 may still be in its infancy, but investors already know it’s going to be a volatile year. First, there’s President Donald Trump’s economic action plan to cut taxes and increase spending. Will this translate into sustainable economic growth? What about Donald Trump’s perceived protectionist views? Will it lead to a trade war with China and Mexico?

Will the U.K. get the clean Brexit it’s looking for or will it be drawn out and painful? Ultimately, will Brexit undermine the U.K.’s economic growth and cobble the fragile European economy?

Speaking of Europe, there are a number of key elections taking place this year in Europe: the Netherlands, France, Germany, and Italy. Unexpected results could destabilize the already fragile region.

Lest we forget the sabre rattling from North Korea, geopolitical tensions in the Middle East, and terrorist attacks. All of these events will have an impact on the U.S. economy, and by extension, the stock market.

So, does Warren Buffett see investors as being fearful or greedy? Or is the Oracle of Omaha taking the rare step and waiting on the sidelines to see what happens?

Warren Buffett Indicator Show Stocks Are Significantly Overvalued

How does Warren Buffett continually manage to pick stock market winners? His investing strategy is simple. Invest in undervalued, shareholder-friendly companies, with strong competitive advantages.

Or, put another way, Buffett buys good stocks at the right time. Moreover, while Berkshire Hathaway doesn’t provide dividends, each year, Berkshire receives billions of dollars in dividend payouts that are dutifully reinvested. And lastly, Buffett’s favorite holding position is forever.

Right now though, it seems as though Warren Buffett is going to have a hard time finding undervalued stocks to invest in. In fact, according to Buffett’s favorite valuation metric, stocks are significantly overvalued.

The market-cap-to-GDP ratio is affectionately referred to as the Warren Buffett Indicator. Back in 2001, Buffett told Fortune magazine that “it is probably the best single measure of where valuations stand at any given moment.” (Source: “Warren Buffet On The Stock Market,” Fortune, December 10, 2001.)

As the name suggest, the Warren Buffett Indicator compares the total price of all publicly traded companies to GDP. It is a great tool to correlate stocks to valuations. After all, stocks are a reflection of the broader economy and there should be some sort of link between economic output and earnings. On top of that, this should also be reflected in stocks and their valuation, and help investors decide whether or not they should buy, sell, or wait.

By all accounts, Warren Buffett is waiting.

A reading of 100% suggests U.S. stocks are fairly valued. The higher the Warren Buffet Indicator is over 100%, the more overvalued the stock market. The market-cap-to-GDP ratio is currently at 127.1%.

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The Warren Buffett Indicator has only been higher twice since 1950. In 1999, the height of the dotcom bubble, the ratio was at 153.6%. In late 2015, it was at 129.7%. It was only at 108% before the 2008 Financial Crisis.

2 Other Indictors Show Stocks Are Significantly Overvalued

Another key valuation metric also suggests stocks are significantly overvalued. According to the Case-Shiller CAPE (cyclically adjusted price-to-earnings) ratio, the S&P 500 is overvalued by 75%! The 10-year average is around 16. Today, it’s at 28.06.

That means, that for every $1.00 of earnings a company makes, investors are willing to pay $28.06.  The ratio has only been higher twice: 2000 and 2007. Both times it was followed by a crash. (Source: “ONLINE DATA ROBERT SHILLER,” Yale, last accessed January 19, 2017.)

According to Nobel-winning economist Robert Shiller, the euphoria after Trump won the election has sent the markets into a frenzy of greed and irrationality that could send stocks plunging in a rerun of the 1929 stock market crash.

Warren Buffett and investors may have to wait a bit for that kind of crash to materialize. The early days of Trump will create a boom. But that too will end; when the Case Shiller P/E ratio gets closer to 45—where it was before the dotcom bust. (Source: “Trump will carry Wall Street to the giddy heights of the 1920s before a fantastic crash, economists warn,” The Telegraph, January 18, 2017.)

Finally, the Wilshire-5000-to-GDP is a market-cap weighted index of all stocks actively traded—U.S.-headquartered stocks that trade on the major exchanges—although the index is made up of around 3,700 components, not 5000. The Wiltshire is less well known than the other two but it is actually the largest index by market value in the world. The ratio is at an all-time high of around 139.1. (Source: “Wilshire 5000 Total Market Full Cap Index©/Gross Domestic Product,” Federal Reserve Bank of St. Louis, last accessed January 19, 2017.)

Stocks are overvalued. It’s as simple as that. Eventually though, stocks and their valuations will come more into line. For that to happen, stocks will need to crash. Thanks to weak global economic indicators, this reality may not be far off. Corporate earnings are down and the outlook for 2017 is weak. If Trump’s economic roadmap fails to create any meaningful change in the coming months, you can expect impatient investors to react.

Warren Buffett Sitting on Record Stash of Cash

Another way we know the outlook for stocks in 2017 is entirely up-in-the-air is because Warren Buffett is sitting on a record stockpile of cash. Rich people don’t sit on cash when interest rates are near zero if there are undervalued companies to buy.

At the end of the third quarter of 2016, Buffet’s Berkshire Hathaway was sitting on a record $85.0 billion in cash. That’s up from the end of the second quarter of 2016 when he had a record $72.7 billion in cash on the books.

At the end of the second quarter, the S&P 500 was in record territory near 2098; it’s eight percent higher now at around 2262. At the end of the third quarter, the S&P 500 was in new record territory near 2168; the S&P 500 is 4.3% higher than that now.

You can expect Buffett to be sitting on a new record stash of cash when he makes his fourth-quarter regulatory filing.  The S&P 500 ended 2016 at 2238 and remains near record levels.

In the third quarter of 2016, Berkshire operating earnings increased 6.6% to $4.85 billion, or $2,951 per share. Net income was down 24% year-over-year after Buffett booked a big gain on an investment in Kraft Heinz Co (NASDAQ:KHC). In 2016, he purchased battery-maker Duracell. He also completed one of his largest deals with the $37.0-billion buyout of Precision Castparts Corp. (NYSE:PCP), a supplier to the aerospace industry.

$85.0 billion dollars is a lot of money. And Buffett could increase his stable of operations with that money. Granted, not all of that money is going to be used for acquisitions. Buffett has said he likes to keep a safety net of at least $20.0 billion.

Still, in light of an overvalued stock market, what can Buffett do with that money? Investors have been calling for Berkshire Hathaway to pay a dividend for years. But Buffett has resisted, saying his astute acquisitions and stock picks will benefit shareholder more over the long run.

If the money is burning a hole in Buffett’s pocket, he could always do what other cash rich companies do, buy back their stock.

Buffett is authorized to purchase shares of Berkshire Hathaway for less than 120% of book value. But that figure could be adjusted. Berkshire Hathaway’s book value of $163,740.08 puts it within 132% of book value.

If the markets are overvalued though, there’s only one spot Buffett is going to put his money, and that’s probably in his own company. At 132% of book value, many analysts still see Berkshire Hathaway as cheap, with a lot of upside when it comes to earnings.

Warren Buffett’s Actions Point to Stock Market Crash

Again, actions speak louder than words. And Buffett does not seem all that sure about the near-term direction of the stock market. His favorite valuation ratio says stocks are overvalued by 27%. You can’t buy low when the markets are too high. Second, he’s sitting on a record pile of cash. And the most attractive undervalued stock right now is probably his own.

Will the stock market crash in 2017? As it currently stands, everything is in place for stocks to experience a serious correction in the coming months.

As for a stock market crash…that is not entirely out of the question for 2017. Investor optimism about Donald Trump is high and it could send stocks considerably higher before investors really know how his policies will affect the broader markets.

Keep in mind, there are a lot of black swan events that could send stocks into a tailspin in 2017. This is when the Oracle of Omaha shines, when investors are fearful and running for the exits. And with $85.0 billion in his pocket, Warren Buffett could make some stellar acquisitions and stock purchases when the markets have crashed.