I talked in a previous post about the Buffett Indicator. Generally, it is a way to tell if the market as a whole is over or under valued. Is this macro economics at work? Or good actionable data? Or both?
The Buffett Indicator is generally the the total market capitalization of all companies divided by Gross Domestic Product. And you can put your own spin on when this is a high number and when it is a low number, but when this number is higher there is a higher likelihood of a market downturn then when this number is lower. In more recent times 200% is high (market cap is 2x GDP) and 100% or below is low.
Since we are almost at 200% right now, does that mean that a market downturn will happen next week? Well no. The market could have another day of bull market gains, or there could be another 2 years. Predicting the future to the day is near impossible. Knowing though that rain is in the forecast is nice because you know to carry your umbrella with you to work. Even if it doesn’t rain.
So again is this macro economic prediction? No it’s just a way to measure a likelihood. Is it good actionable data? I believe so. Here is what I think you can do: build a cash position when the Buffett Indicator is high. Generally this means that the cash you would normally put in your brokerage account goes into fixed income for a while. No need to sell stock to raise cash, just build cash from what you would have newly invested.
Some people may feel the need to sell stock to raise cash and that is completely up to you. Somehow you should slowly start to build a cash position and if all you can do is sell a little stock to do this, I guess that’s ok. But you don’t have to. If you sell stock, you might miss out on some incredible gains.
So you have some cash now and it’s built to a decent position, what do you do with it? Wait until the Buffett Indicator is low and make some purchases of good quality stocks. You may want to wait until the market starts building again, which is usually a few months in a recession.
How much is too much cash? That’s a good question… How much do you want to have when prices get really cheap? Maybe 35% cash versus your total investments? It’s really up to you, you can make this choice. Do I know how much I will raise? Not really, I don’t really think there is a number I can save fast enough to make it too much.
Is the Buffett Indicator fool proof? Over time things have changed and maybe a higher market cap is ok. It seems like it is compared to the 1980’s. Check out the chart in the link below. We’ve had a tremendous run up in the 2000’s and I still think we could go for a while. Still it’s nice to have some cash for that rainy day when it does come.