David Sterman

What are stocks worth?

It's a loaded question. Any stock can appear overvalued or undervalued depending on which valuation metrics you use.

The same logic applies to the broader stock market. Right now, some think the market is undervalued as the U.S. economy appears poised for a solid long-term upturn. Others think we're headed for a market downturn as the Federal Reserve winds down its aggressive liquidity-boosting efforts.

Yet by at least one measure, which happens to be a favorite market gauge for Warren Buffett, the market has just become overvalued.

The economy and the market
Buffett thinks the value of all stocks in the Wilshire 5000 Total Market Index should be worth less than the U.S. gross national product (GNP). And you can bet it's a key consideration he makes when looking at Berkshire Hathaway's (NYSE: BRK-B) portfolio. The GNP stood at $16.13 trillion at the end of 2012, according to the Bureau of Economic Analysis. Well, the Wilshire 5000 hit that mark on March 4, and has subsequently risen to $16.57 trillion. That difference may seem trivial, but history tells us the gap should be seen as a sell signal.

The Wilshire 5000 index was created in 1974 to capture the total value of the 5,000 largest companies on the various U.S. stock markets. (An aside: The steady attrition of publicly-listed companies during the past decade means there are now fewer than 5,000 companies in the index.)

Since the advent of the Wilshire 5000, it has exceeded the value of the U.S. GNP on only two occasions: 1998 and 2007. In each case, the market rose yet higher but eventually tumbled sharply. In fact, after the threshold was crossed in 1998, the market rose another 40%. Nonetheless, the market eventually stumbled so badly (as the Wilshire 5000 fell a hefty 40% from its March 2000 peak) that investors had a right to be nervous throughout the latter stages of that rally.

David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com

Get the best of Townhall Finance Daily delivered straight to your inbox

Follow Townhall Finance!