Over the last four years, the S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) have been practically unstoppable in their continued march higher. Despite a number of potentially dislocating events, investors have bought into stock price pullbacks, pushing the indexes to new all-time highs this year. But as the bull market approaches its four-year anniversary, stocks, as a group, have never looked more expensive.
Twenty-five years ago, as the dot-com bubble popped, Warren Buffett shared a simple metric he called "the best single measure of where valuations stand at any given moment." Today, that metric is hitting new record highs, indicating a severely overvalued stock market. Luckily, Buffett's timeless wisdom can also point investors toward market opportunities. Act 2 Could Be 15x Bigger.
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Continue » Buffett's top metric for market valuations has come to be known as the Buffett indicator since he first published it in 2001. The calculation is simple: Take the total market cap of the Wilshire 5000 index, the broadest U.S. stock market index, and divide it by the U.S. Buffett warned, "If the ratio approaches 200% -- as it did in 1999 and a part of 2000 -- you are playing with fire." Today, the ratio sits around 240%, the highest it's ever been.
It's not the only valuation indicator at or near all-time highs. Much has been written about the price-to-earnings (P/E) ratio and cyclically adjusted P/E ratio of the S&P 500. Both sit near levels last seen in the dot-com bubble.
The equity risk premium is shrinking as well. Margin debt is also hitting new records and climbing fast. But before investors start running for the hills, there are a few important factors to consider.
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