Warren Buffett Indicator Predicts Stock Market Crash in 2018
On October 31, Halloween, children and adults alike enjoy playing with the frightful themes of death surrounding the feast’s mixture of Christian All Saints’ Day and Celtic pagan origins. But, in 2017, if you are one of millions of people who have investments, here’s something all too real and scary to rob you of your sleep. This Warren Buffett Indicator predicts a stock market crash in 2018.
You might be wondering if we’ve endured one too many ghost apparitions. To suggest that no less than Warren Buffett, whose net worth is north of $80.0 billion, expects the market to reverse its bullish course seems not just scary, it seems silly. But Warren Buffett’s predictions for 2018 call for at least a market correction—if not an outright crash.
A famous Warren Buffett motto that applies to investing is that investors should “be greedy when others are fearful and fearful when others are greedy.” (Source: “Warren Buffett’s big bank score proves his saying true once again: ‘Be greedy when others are fearful’,” CNBC, June 30, 2017.)
Only unbridled, and most likely irresponsible, euphoria has been driving the Dow to exceed 23,300 points in these last few weeks of 2017. According to Buffett’s motto, a majority of investors are all but fearful. They are positively ravenous with greed. Therefore, this is no time for the wise to be betting their savings in the stock market.
This Is No Time to Gamble
This is a time for contemplation; reflect on the wealth you have and keep it. Don’t gamble it away. Indeed, to describe the present scenario, it would be an insult to call it a market. It’s much more a casino. And this is where Warren Buffett’s warnings become important. It’s not so much Warren Buffett’s predictions for 2018 that count. Buffett tends to make longer-term analyses. For example, his latest major prediction is that the Dow Jones could hit 1,000,000 points in 2118. That’s well over 40 times the current number.
Buffett is being optimistic. In fact, if history can offer any lessons, note that the Dow Jones 100 years ago, in 1917, stood at 1,328 points. That would be less than 20 times the current number. But Buffett probably doesn’t have to worry too much about the events that may or may not occur in the 22nd century. Now, as far as the present is concerned, you can be sure that Buffett chooses his words and predictions more carefully, as it were.
Thus, Buffett has not said anything specific to the effect of “the stock market will crash in 2018.” He doesn’t have to make any such statement. An expert prediction is just that: a prediction. The smarter the expert, the less tendency there is to trust forecasts and prophecies. But if you use the expert prediction as a guide to understand what’s happening, you can detect trends. Thus, you can prepare and take appropriate actions that will not leave you stranded. If the negative predictions do materialize, you can take comfort in the fact you were ready. If they don’t, you can enjoy the favorable outcome with everyone else.
One of the reasons Warren Buffett’s predictions tend to have more weight is that they’re less based on outright fortune telling and more on a series of clear indicators. In other words, the Warren Buffett Indicator works like a barometer. It does not predict rain, per se, but it does tell you whether you should look for an umbrella in the closet to keep it handy for the next day.
The Warren Buffett Indicator is less mysterious than it sounds. It might as well be called the common-sense indicator. It’s simply the relationship between gross domestic product (GDP)—or the sum total of a country’s economic activity—and the value of stocks in the S&P 500. So, in simpler terms, the Warren Buffett Indicator in terms of Wall Street measures market capitalization versus U.S. GDP. (Source: “Why Warren Buffett Is Betting Against Warren Buffett,” Seeking Alpha, October 24, 2017.)
Now, the market cap-to-GDP ratio is about 137%. That’s high, very high. When this ratio is around 60%-75%, the market is considered undervalued. When it’s about 95%-100%, it’s a Goldilocks market; just right. When it’s above 115%, look out, the pot is going to blow. We’re at 137%, well beyond “terminal velocity.”
The One Biggest Risk for the Stock Market in 2018
In a less extreme market—for example, one where the Warren Buffett Indicator is around 100 or less—the risks are easier to identify, count, and classify. But in a situation where this indicator is approaching 140%, it’s clear that we’re long past the realm of logic. The markets are ignoring all risks while the Dow keeps climbing. Yet, there is one major risk at the macro level that could slam open the doors for a crash.
Will the Stock Market Rally End in 2018?
The Dow Jones is flying, but the risks of a crash are many and ready to materialize. Donald Trump was elected almost a year ago, at the time of writing. The markets were supposed to have crashed. They did for a few hours. Despite the many protests, marches, and witch hunts that the 2016 presidential election has caused, the Dow has gained about 30% since November 8, 2016.
The NASDAQ has surged by a similar percentage. In other words, the winds that brought Trump to the White House fueled some $5.0 trillion into Wall Street’s market capitalization. How much more energy can this already remarkable—and improbable—rally have? Chances are the rally will taper off. It could do this gradually or with a bang—that is, a crash.
Will the Next Stock Market Crash Strike in 2018?
What on earth could be responsible for such optimism? After all, the oft-repeated adage that Trump’s tax cuts have been feeding the bulls on Wall Street has run its course. The tax cuts have not been approved and with the divide in Congress—a divide also within Republicans themselves—there’s little chance of the major reductions occurring. Moreover, the U.S. debt now exceeds $20.0 trillion.
No expert prediction or technical indicator is necessary. The makings of the next crash are already clear. Whether it’s Janet Yellen or Jerome Powell who will head the Federal Reserve after February 2018, interest rates can only move higher. At the current rate of debt, even 100 basis points (one percent) higher interest will mean $200.0 billion in additional (not all, mind you, just the extra bit) in debt.
How does this affect the stock market? Could it cause another Black Monday? The answers are rather direct. Yes and yes. If there’s anything you can bet on in 2018 or even in this latter part of 2017, it’s that a major market correction such as what happened on October 19, 1987—that is, Black Monday—looks likely.
On Black Monday, the markets were a bit different than today. That’s the explanation that many market optimists like to offer when they explain why another Black Monday can’t happen. That is, the market cannot lose some 23% of its value in a single trading session. They might be right, but in the opposite direction. The markets now have human as well as computer input through so-called robot trading. They have more variables and are more complicated. But information and risks travel much faster. If anything, the risks of a major market crash are higher today.
The price-to-earnings (P/E) ratio now is around 20 times. In many cases, for some of the star stocks of 2017, the P/E ratio is completely different. The P/E ratio for Tesla Inc (NASDAQ:TSLA), for instance, in 2018 is -411.37. (Source: “Tesla, Inc. Analyst PE Estimates,” NASDAQ, last accessed November 1, 2017.)
Indeed, Tesla’s performance has all the makings of a stock market crash chart to reflect the irrational exuberance of 2018. Investors have pushed Tesla’s stock market valuation to such a degree that it has infected the healthiest hedge fund. It’s a one-stock Black Monday warning! Note the Tesla stock market chart. It’s moving on hope and expectations alone; every time the quarter results are released, the stock tends to drop.
Chart courtesy of StockCharts.com
We’re Past Black Monday. The Situation Is More Dramatic
It’s beyond Black Monday. The next stock market crash will combine the effects of Black Monday with the tech bubble of 1999-2000 and the recession that resulted from the crash of 2007-2008. The Shiller CAPE ratio, which measures a stock’s performance by comparing its price against earnings over a 10-year period, has reached the very point when Alan Greenspan pronounced his famous “irrational exuberance” speech. (Source: “The stock market’s valuation is back to the point where Greenspan warned of ‘irrational exuberance’,” CNBC, October 31, 2017.)
The Shiller CAPE ratio now stands at just over 31. It was only higher before 1929 and the dotcom bubble. It’s time to fasten your seatbelts; the market ride is going to get bumpy. But in the dotcom 1990s, there was some real economic growth. Now, one of the indicators of overall economic health, the retail sector, is falling apart.
The number of major store chains shutting down or downsizing is remarkable. One of the latest to fall is Toys “R” Us. Some may find consolation in the fact that one of the reasons for the crumbling of traditional brick-and-mortar stores—but by no means the only one—has been Amazon.com, Inc. (NASDAQ:AMZN). But the day could come when even this giant is slain.
Thus, when you combine factors like irrational exuberance, the Warren Buffett Indicator, and signals from the real economy, you realize this. All that separates the markets from a major crash is a single spark. The pyre is ready.