Warren Buffett's favorite market indicator nears record high, signaling stocks are overvalued and a crash may be coming

• Warren Buffett's preferred market indicator is approaching a record high, suggesting stocks are overpriced and could tumble soon.
• The "Buffett indicator" compares the total value of the stock market to quarterly GDP, gauging whether it's overvalued or undervalued relative to the size of the economy.
• The ratio climbed past 180% on Tuesday, not far off its peak of 187% in the second quarter, when GDP was 8% lower.
• Buffett praised the gauge as "probably the best single measure of where valuations stand" and called it a "very strong warning signal" of a market crash.
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Warren Buffett's favorite market gauge is flirting with a fresh high, signaling stocks are overvalued and could plunge in the coming months.

The "Buffett indicator" divides the total market capitalization of a country's publicly traded stocks by its quarterly gross domestic product. Investors use it as a rough measure of the stock market's valuation compared with the size of the economy.

The Wilshire 5000 Total Market Index surged to $38.2 trillion on Tuesday, while the latest official estimate for third-quarter GDP is $21.2 trillion.

Dividing those numbers shows that the Buffett indicator has cleared 180% — not far off its peak of 187% in the second quarter, when GDP was about 8% lower, and a big jump from 170% in early November.

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Buffett described his namesake gauge in a Fortune magazine article in 2001 as "probably the best single measure of where valuations stand at any given moment."

The famed investor and Berkshire Hathaway CEO added that when the ratio spiked to a record high during the dot-com boom, it "should have been a very strong warning signal" of a crash. The Buffett indicator also surged in the months before the 2008 financial crisis, giving it a solid track record of predicting market downturns.

However, the gauge is far from perfect. Comparing the current value of stocks to the previous quarter's GDP isn't ideal, US-listed companies don't necessarily contribute to the American economy, and GDP doesn't account for overseas income.

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The COVID-19 pandemic has also caused massive disruptions to economic activity and temporarily depressed GDP, boosting the Buffett indicator's readings in recent months. But stocks appear extremely expensive by several other measures, suggesting the gauge isn't wildly off the mark.

Here's the St. Louis Federal Reserve's version of the Buffett indicator (both market cap and GDP are indexed to the fourth quarter of 2007):