Each the S&P 500 and Nasdaq Composite indexes reached new all-time highs yesterday (9 July). Whereas that’s undoubtedly nice information for Warren Buffett’s large Berkshire Hathaway inventory portfolio, it additionally brings a extra regarding valuation indicator into focus.

The truth is, this metric is now at a report excessive, doubtlessly serving as a crimson flag traders.

The ‘Buffett Indicator’

Again in 2001, Warren Buffett revealed what he thought of to be “in all probability one of the best single measure of the place valuations stand at any given second“.

This valuation metric, now generally often known as the ‘Buffett Indicator’, divides the full market capitalisation of a rustic’s inventory market by its annual gross home product (GDP). It tries to roughly gauge whether or not the market is overvalued or undervalued.

A excessive market cap-to-GDP ratio (over 100%) means that shares are overpriced relative to the financial system, signalling potential danger. A disconnect between financial actuality and share costs, primarily.

At present, this ratio stands near 200%. That’s nicely above the 159% seen simply earlier than the dot-com bubble!

Happening this then, it could be very dangerous to start out ploughing cash into US shares as we speak. Maybe that’s why Buffett’s Berkshire has been a internet vendor of shares for six consecutive quarters.

Some nuance is required

Now, I ought to level out some caveats right here. The primary is that no metric is ideal in isolation. Certainly, whereas many market watchers nonetheless comply with the indicator carrying his title, Buffett has really backed away from it.

One downside is that the majority massive firms generate important income from worldwide markets, making GDP doubtlessly much less related.

Furthermore, whereas Buffett and his investing staff might promote or trim positions, they don’t offload all their shares fully. Berkshire’s very best holding interval for a inventory stays “endlessly“.

Lastly, the Buffett-inspired metric highlighted right here pertains to shares listed throughout the pond. It doesn’t apply to most UK shares, which proceed to look low-cost by historic requirements.

How I’m responding

Proper now, I’m targeted on beefing up different areas of my portfolio the place I see extra worth. One is in FTSE dividend shares, a lot of which proceed to hold large yields.

An awesome instance is British American Tobacco (LSE: BATS), a inventory I’ve been scooping up not too long ago.

This is likely one of the world’s largest cigarette corporations and owns manufacturers like Dunhill and Fortunate Strike, in addition to main vaping model Vuse.

The headline attraction with the inventory is its mammoth 9.4% dividend yield. If forecasts show appropriate, this rises to almost 10% by 2026. That may be almost £100 again in dividends from each £1,000 I make investments!

Now, forecasts don’t all the time show appropriate and dividends are by no means assured. And one motive the yield is so excessive is because of declining cigarette gross sales, significantly within the US. This stays an actual danger.

Nonetheless, to counter this, British American Tobacco is elevating costs to maintain revenue margins (and dividends) fats. Extra importantly, it’s constructing up its non-cigarette unit, which incorporates vapes and tobacco pouches.

These merchandise now make up round 12.5% of income and the division achieved profitability in 2023, two years forward of schedule.

Lastly, the low ahead price-to-earnings (P/E) ratio of 6.8 seems to supply an honest margin of security. It’s a 58% low cost to US rival Philip Morris Worldwide.