Warren Buffett once famously said, "Be fearful when others are greedy and greedy when others are fearful."
Which begs the question.
With one of his favourite stock market indicators signalling a market crash ahead, should we be fearful or greedy?
What is the Warren Buffett stock market indicator telling us?
The Oracle of Omaha didn't amass a personal fortune of more than US$100 billion by taking wild risks.
Instead, the now 92-year-old CEO of Berkshire Hathaway has played the long game, looking for undervalued stocks with plenty of barriers to entry to deter would-be competitors.
So when Warren Buffett starts to sell down stocks, it's worth taking note.
Indeed, Buffett was a net seller during the first quarter of 2023, with Berkshire closing out four positions and cutting exposure in nine. Q1 saw Berkshire add three new positions and increase exposure to six others.
The billionaire investor may be increasing his cash holdings with an eye on one of his favourite market indicators.
This metric divides the total market caps of all the US stocks by the US GDP. Any outcome above 100% is said to indicate that the market is overvalued. On the flip side, when GDP outstrips the total value of the stock market, Warren Buffett has said that there could be some bargains to be had.
Has the indicator been accurate?
While it's no perfect gauge, the billionaire's market indicator has accurately forecast the past three major market meltdowns.
Before the 2000 dot-com bubble burst, it was well above 100%. The indicator again jumped above 100% shortly before the global financial crisis of 2008. And then once more before the market collapsed in 2022 when the S&P 500 Index (SP: .INX) went on to crash 19%.
As for right now, the Warren Buffett indicator is at 153% for US stocks. While that's down from the 2022 peak, it's above the reading right before the dot-com crash.
The indicator is in the danger zone for global stocks too. The total market cap of stocks around the world divided by global GDP has leapt to nearly 110%.
But don't panic just yet.
While the indicator is elevated, it's been almost 10 years since it was below 100% for the US market.
That could be because US stocks are overvalued, driven by more than a decade of ever-lower interest rates prior to last year's tightening cycle. Or it could be that the listed companies are simply worth more than they were 20 years ago relative to the nation's GDP.
It's likely a bit of both.
So, I wouldn't let the elevated level of the Warren Buffett indicator scare me from trying to scoop up some potentially profitable ASX shares or US stocks.
But I wouldn't ignore it entirely either.
If Buffett's indicator proves right again, I plan to have some extra cash on hand to make the most of any unwarranted price falls during a market crash.
