If you have ridden the bull market to higher and higher levels, is it time to take a little off the table and realize profits? The old saying is, by the way, that you do not have a profit until you take a profit. Is this going to be a painful correction for unwary investors? Market Watch notes one warning indicator which says that serious pain awaits investors.
One of those measures, in particular, has popped up on investor radars lately, and that’s the “Buffett indicator.” The Berkshire BRK.A, +2.83% boss called it “the best single measure of where valuations stand at any given moment.” If historical patterns hold true, a thrashing could be in store for complacent investors.
Put simply, the indicator is the total market cap of all U.S. stocks relative to the country’s GDP. When it’s in the 70% to 80% range, it’s time to throw cash at the market. When it moves well above 100%, it’s time to lean toward risk-off.
Where’s it now? Approaching 140% and a new record high.
A successful long term investor like Buffett relies on the strength of the US economy to drive up the value of his investments. Using intrinsic value as a guide, value investors buy stocks that they understand and stocks that are underpriced in relation to expected long term earnings. Those long term earnings are usually tied to the strength of the US economy. When the value of all US stocks grossly exceeds the value of the US economy, a painful correction is in store.
How Painful Might a Correction Be?
The last two times the total market cap of all stocks grew above the US gross domestic product, the end results were the 2008 stock market crash and the dot com crash. In each case, the losses were huge. The dot com crash erased about $6 Trillion in value. The 2008 financial crash erased closer to $14 Trillion. In the 2008 crash the S&P 500 was cut in half before it started to rise again.
Benefiting from a Market Correction
All of that having been said, not everyone lost money in the dot com and 2008 market crashes. Those who had the foresight to buy puts on their big winners walked away with their profits (minus the cost of the option contracts). Those who simply purchased puts on the most vulnerable stocks made out like bandits and are probably sipping rum drinks and lounging by their pools on their own tropical islands.
Timing a Market Correction
Because perfect market timing is impossible, it can be really difficult to decide when to get out and when to stay in. This is where options are useful because, for a small insurance fee (the premium) one can protect an investment portfolio or nail down a selling price throughout the duration of the options contract. All of this you can do for simply the premium paid for the contract. The leverage that options trading offers can result in spectacular profits when other unwary investors are losing their shirts.