There are no shortage of Warren Buffett quotes on successful investing. The one that never fails to reassure me? “Be fearful when others are greedy and greedy when others are fearful.”

If one of the greatest investors on the planet strongly suggests that one become risk averse when the herd is throwing caution at the proverbial wind, it makes sense to identify the extent of ill-advised risk taking. For example, the CBOE S&P 500 VIX Volatility index (a.k.a “fear gauge”) closed out September at its lowest level on record, suggesting that there is very little regard for the possibility of a precipitous stock decline.

lowest-volatility-in-history

Other fear-greed measures are equally disquieting. In spite of a flawless run-up since the November election, where stocks have catapulted higher for 11 consecutive months, sixty-five percent of Americans believe that stocks will rise over the next 12 months. This particular percentage of optimism (65%) represents a record level of confidence in equities.

graphic-2-euphoric-lack-of-fear

Perhaps the most compelling evidence? Cash allocation levels. Cash levels have moved to record lows – levels that are reminiscent of the dot-com tech bubble (2000) and subsequent recession (2001).

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Not surprisingly, Warren Buffett has become risk averse with his holding company, Berkshire Hathaway (BRK.A). He is not adding meaningfully to current positions. He is not putting billions to work in new positions or acquisitions.

On the contrary. While the typical investor has never had more confidence in putting his/her cash into riskier assets like stocks, Mr. Buffett has never had more of his money sitting in the safety of low yielding cash.

buffett-so-much-cash

Warren Buffett’s cash allocation likely reflects another one of his timeless principles. The quote? “Rule Number 1: Never lose money. Rule Number 2: Never forget Rule Number 1.”

In particular, cash is one of the most effective hedges against the risk of severe financial loss. You also get to use it to scoop up incredible bargains at lower prices.

Gold? Treasuries? Both have had a variety of periods of success in stock downturns. Depending on the nature of the stock bear, however, precious metals and/or government debt may not succeed in protecting portfolios. Meanwhile, low-yielding cash would cushion the blow with greater certainty than gold or government bonds in an exceptionally uncertain environment.

With one of the most successful investors on earth cognizant of his rules – Rule Number 1 and Rule Number 2 – Mr. Buffett is clearly insulating Berkshire Hathaway (BRK.A) against the probability of monstrous price depreciation. Yet he is not merely relying on the diversity of sentiment indicators described above. He is also paying attention to traditional measures of valuation.

For example, market capitalization-to-GDP is a long-term stock valuation indicator. Analysts often cite its efficacy in terms of its high correlation (0.89) with subsequent 10-year returns. More fascinating? The measure is routinely described as the ‘Buffett Indicator’ due to his statement in a 2001 interview that market cap-to-GDP is “probably the best single measure of where valuations stand at any given moment.”

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On the ‘Buffett Indicator,’ stocks are far more overvalued than they were leading into the financial crisis (10/07), and they are within a stone’s throw of the Internet bubble (1/00). In fact, most measures of valuation demonstrate similar frothiness – exuberance last seen in 1929 and 2000.

valuations-oct-2017

Additionally, we have household equity exposure. Its correlation with subsequent 10-year returns is 0.91. It is so high, in fact, it eclipses market cap-to-GDP (.89) and P/E measures that tend to clock in between 0.76 and 0.83. According to Ned Davis Research, whenever average equity allocation percentages have topped 40%, subsequent 10-year returns have been nothing short of abysmal.

average-investor-equity-allocation

Fundamental indicators are not the only tools that suggest stock prices have decoupled from sensibility. Consider the long history of the S&P 500 ($SPX) typically touching its annual exponential moving average (EMA). At the time leading into the tech wreck (1999-2000) and prior to the financial crisis (2007), the S&P 500 significantly divorced itself from its annual EMA. In 2017? The fact that the S&P 500 is currently 18.8% above its annual EMA with virtually no downside price movement is a clear warning sign for technical analysts.

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It should be abundantly clear to fans of Warren Buffett’s value orientation and risk management guidance that stocks have rarely been as risky as they are right now. Perma-bulls disregard all of the evidence, pointing to ultra-low interest rates. What’s more, Mr. Buffett himself has changed his tune on the importance of the valuation tool that carries his name (market cap-to-GDP) as well as explaining that stocks look fairly priced relative to interest rates.

Really?

I have to believe that Warren Buffett is completely aware of the low rate screenplay that existed for 20 years in the previous century (1935-1954). If low rates are the only thing that matter for stock valuations, then why did investors experience four bear markets in that 20-year period? They include 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), and 1946-1947 (-23.2%).

10-year-yeild-throughout-history

There’s more. Take a second look at the chart of traditional valuation metrics between 1935 and 1954 in the previous chart of traditional valuation metrics. (I am re-posting it below for the reader’s convenience.) Valuations throughout the 20 years of low interest rates (1935-1954) were, on average, a fraction of where they are here in 2017. Same low interest rates. Much lower PEs and Q Ratios across those 20 years (1935-1954) compared with today.

valuations-oct-2017

So which Warren Buffett should we believe? The one who says to be fearful when others are greedy and greedy when others are fearful? And the one who says “Rule Number 1: Never lose money. Rule Number 2: Never forget Rule #1?” And the one who says that market-cap to GDP is the greatest single measure of present valuations? Or should one be listening to the legendary investor who has suddenly placed interest rates above all else, in spite of the historical evidence demonstrating the folly of banking on borrowing costs alone?

I have a theory about why Mr. Buffett has downplayed the ‘Buffett Indicator’ as well as played up the interest rate mantra. Even though he is sitting on a pile of cash, he likely believes that the average investor cannot live by his discipline; the typical investor panics.

It follows that, in the absence of discipline, Mr. Buffett would simply prefer that investors hold U.S. stock holdings through thin and thick. Think about it. Imagine if Mr. Buffett went on the airwaves and told investors that he thinks the stock market is utterly crazy and that everyone should get the heck out of the casino… stat! Could you picture it?

Wary of his influence, he may see his role as a calming influence for a financial world that could go completely haywire. Even when it does turn bearish and dire, Mr. Buffett will come out with one of his media pieces, imploring investors to stay the course. Then he will describe all of the wonderful stock opportunities that he is buying with the price discounts.

Here is what I do know: We have a lower allocation to stocks for our retiree and near-retiree client base, down from 70% to 50%. And when the monthly close on the 10-month simple moving average (SMA) breaks, we will cut that 50% back to 30%-33%.

ivy-10-month-sma

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

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