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Buffett’s Indicator Is Calling Tops

It’s up to you to listen.

Because the indicator that Warren Buffett uses to gauge whether the S&P 500 is expensive is trying very hard to tell you something.

This “Buffett-Metric” is the total market capitalization of U.S. stocks relative to the GDP of the country.

Today that metric sits at almost 139%, a number that has been eclipsed only once before in the entire history of the US stock market.

That was at the peak of the tech bubble in 2000 when the “Buffett-Metric” hit 145%, and it only held that level only for a few short weeks before the market crashed…

The chart below shows the peak of the “Buffett-Metric” in 2000 and the subsequent fall. The chart also shows how frothy the reading is on this metric today.

Today we are but a whisper away from equaling that brief all-time valuation peak of US stock market capitalization to US GDP of 145%.

If you stick your head in the sand and pretend that this isn’t anything to be concerned about, you aren’t going to like what comes next.

So don’t do it. Use that head of yours to think because it’s not too late to do something about this.

The Cause This Time – Too Much Mindless Investing

I’m not a doom and gloom kind of guy.

But I am rational.

The “Buffett-Metric” has only been this high once before, and it only held this level for a very, very short period of time.

I don’t see how a rational person can see that we are at an all-time valuation high and not think that the market is expensive.

If an all-time valuation high isn’t expensive then what exactly is?

This time, the reason for these high valuations is the massive amount of money that has flooded into passive index funds and ETFs in recent years.

These passive vehicles buy the exact same stocks with no thought whatsoever given to valuation.

If you give an index fund a million dollars it is just as happy to buy stocks trading at 3,000 times earnings as it is to buy stocks trading at 6 times earnings.

This is mindless investing.

That isn’t an insult by the way. Mindless investing is the stated objective of an index fund.

But…

When the amount of money managed mindlessly gets to be outrageously large you can see how strange things can result.

Which is exactly what has happened.

Hundreds of billions of dollars have been sucked out of actively managed (thoughtful) funds and put into passively managed index (mindless) funds during this current bull market.

All of this mindless index fund money ends up chasing the same stocks, the stocks that make up the underlying indices. With hundreds of billions of mindless dollars chasing the same stocks, you end up with some crazy valuations.

A crazy valuation like Amazon trading at 242 times earnings. Or a crazy valuation like Tesla having a $54 billion market capitalization despite being a massive cash burning operation.

The extreme valuation of some stocks have made owning the entire S&P 500 index a risky proposition.

Not To Worry – We Can Work With This Index Fund Bubble

Index fund investing is a great idea. It is low cost, low stress and over time has worked very well.

But like anything, taken to excess it isn’t great. Which is what we are seeing today.

The flood of money into index funds has made the overall market expensive, but there is a great disparity between how expensive individual stocks are.

That is why I think investors need to avoid exposure to the Amazon, Tesla, and Netflix-type valuations that are dominating the index and focus on other areas.

I’m referring to stocks that are not included in the main indices.

I showed you in the above chart that as the market has roared higher in recent years, much of the cash that has poured into index funds has come out of actively managed funds.

Over this stretch of time, passive index funds have outperformed active managers. That makes sense given that the stocks that the index funds own have been bid up relentlessly by all of the cash chasing them.

At the same time, active managers have been net sellers of the stocks they own that have negatively impacted their fund’s performance.

Now I want to show you another chart. This one compares the performance of active versus passive/index funds over time.

The red shading shows periods of passive fund outperformance. The green shading shows periods of active fund outperformance. The most recent red stretch coincides with our index fund bubble.

The last significant red stretch coincided with the last stock market bubble, which I daresay isn’t a coincidence.

From this chart, it quickly becomes apparent that these stretches of outperformance are very cyclical.

We alternate between periods of outperformance for passive and active funds.

It looks to me like we must be getting close to the time where we have another multi-year run of outperformance for active managers. Yet another sign that hitting the “Buffet-Metric” valuation peak is likely the end of the line or the index fund bubble.

This is something we can profit from.

Let me introduce you to a company called Affiliated Managers Group (NYSE:AMG). Affiliated Managers owns equity interests in a bunch of the very best boutique active asset managers in the business.

Those equity interests are in well-known managers including Tweedy Browne, Yacktman, Third Avenue and ValueAct Capital as well as many other international names that aren’t as familiar to the mainstream (although still great investing shops).

Affiliated is well diversified across 550 different investment products which are situated all across the world. Combined, Affiliated Managers firms manage $770 billion in assets.

The firm has done quite well over the past decade despite the macro headwinds that active managers have faced. As the cycle turns back towards actively managed funds, the $770 billion in assets under management are going to grow quickly.

Trading at 12 times the next 12 months’ estimated earnings, this company trades at a big discount to the overall market and represents a direct way to play the end of the index fund bubble.

Here’s to looking through the windshield,

Jody Chudley
Credit Analyst, The Daily Edge
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