Warren Buffett: Is Another Stock Market Crash Inevitable?

The stock market is surging, even though the GDP is contracting. The Warren Buffett Indicator signals that equities are overvalued and a second market crash is inevitable.

Puja Tayal ❯

@PujaTayal

Puja Tayal has been writing for Motley Fool Canada since 2020. Her love for writing inspired her to start a college newsletter. With a Bachelors's degree in Finance and Accounting and CFA Level 1, Puja strives to transform stock discussions into breakfast table chats through her articles. A movie buff and a finance geek, Puja weaves superheroes, cartoons, and novels to tell you a story touching different aspects of investing, from portfolio and tax planning to retirement savings. Follow her on Twitter for more stories.

Published August 31, 2020 2:45 pm EDT

Recently, you’ve likely heard a lot about the inevitable market crash and the Warren Buffett Indicator. The fears of another market crash increased, especially after Statistics Canada revealed that Canada’s real gross domestic product (GDP) contracted at an annualized rate of 38.7% in the second quarter. This is the worst decline since the GDP data was first recorded in 1961. Even though the GDP contracted, the S&P/TSX Composite Index rose 16%.

The Warren Buffett Indicator hints that the equities are overvalued and the market could crash again. Several points support the market crash theory. But the market just keeps rising. Is another market crash inevitable?

Warren Buffett Indicator

The stock market is one of the measures of how the economy is performing. If consumer demand is high, revenue is high. The GDP will grow and so will the stock market. The Buffett Indicator divides market capitalization with the GDP to arrive at a percentage. A value above 100% shows how overvalued the equities are compared to the GDP.

Currently, the Buffett Indicator is above 180%. It wasn’t that high even before the 2009 financial crisis or the dot.com bubble. These are the two market crashes the Buffett Indicator predicted correctly. The indicator cannot time the market crash.

Why is the stock market still rising?

The market is still rising on the back of Prime Minister Justin Trudeau’s $2 trillion stimulus package. The government spent $71 billion on the Canada Emergency Response Benefit (CERB), which increased household disposable income by 10.8% and tripled the savings rate to 28%. This increased the government deficit by 1,000% but prevented a depression.

As the economy re-opens, the Canadian government is putting in place a $37 billion recovery benefits program that will stay in effect for a year. It will put money in the hands of the unemployed Canadians, thereby preventing the stock market from crashing. Things are holding well so far.

Canadian banks have reported decent earnings, with no dividend cuts. The financial market represents 28.6% of the S&P/TSX Composite Index. The two largest stocks on the TSX — the Royal Bank of Canada and Shopify, which account for 9.4% of the index — have reported strong earnings. The sectors that took a big hit — airlines, restaurants, and real estate —have a lower weighting in the index.

Moreover, the central bank has reduced interest rates, which shifted investors’ money from debt securities to equities. This explains the inflated stock prices.

Is another stock market crash inevitable?

The higher weighting of financial and tech stocks, the stimulus package, more profitable industries, and low interest rates have impacted the Buffett Indicator. While there are no signs of a market crash so far, I will not rule out the possibility of a crash, as virus stocks are trading near their record-high valuations.

If not a crash, there will be a market correction, as the economy recovers and more attractive investment opportunities spring up. Instead of leaving your cash idle, there is a way you can benefit from both a market correction and a market rally.

Invest in Enbridge

Buffett was silent on the buy-side in the March market crash. Instead, he sold his airline and restaurant stocks. After three months, he purchased natural gas transmission business, which is a defensive play, as there is little competition and cash flows are stable.

If you want to replicate Buffett’s strategy, Enbridge (TSX:ENB)(NYSE:ENB) is the stock for you. The company has the largest pipeline infrastructure in North America. It earns 95% of its cash flows from transmitting oil and natural gas to the regions where it has pipelines. It uses this cash flow to pay dividends to shareholders and also increase them.

The pandemic has reduced oil demand. This has reduced Enbridge’s stock price by 25% and increased its dividend yield to 7.6%. When the oil demand recovers, the stock will surge to its normal trading price of over $50, representing a 20% upside.