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.

#-ad_banner-#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.

Nearly a decade later, in 2007, the Wilshire 5000’s value again exceeded the size of the U.S. GNP, and this ratio soon moved up to 105%. But by the year’s end, the index began to slump, foreshadowing an eventual market rout in 2008.

As far as Buffett is concerned, even a return below 100% of GNP doesn’t spell opportunity. He thinks stocks are truly appealing when this measure falls below 80%. This helps explain why he’s been an aggressive buyer of stocks in the midst of deep sell-offs.

An inexact correlation?
There is a bullish argument to be made that “this time is different.” After all, corporate profit margins are near all-time highs, so although the Wilshire 5000 might be in the danger zone in the context of the size of the U.S. economy, it may not be so alarming in the context of corporate profits.

By that logic, it can be argued that an expansion in the value of the Wilshire 5000 depends on stability or growth in corporate profit margins. However, companies have maintained very lean workforces for half a decade and will need to start expanding head count if the economy grows. In such a phase of the U.S. economic cycle, profit margins tend to compress as overhead expenses rise.

Sell in May?
There’s an old adage on Wall Street that it is wise to “sell in May and go away.” And in each of the past three years, we saw a significant springtime pullback. In light of the robust start to 2013, you need to heed the seasonal trends. The Wilshire-to-GNP ratio highlights that concern.

To be sure, the coming earnings season is expected to be generally positive, but the first-quarter earnings season has also proved to be a great time to take profits.

Risks to Consider: The Wilshire-to-GNP ratio could move higher in the near-term, so this isn’t necessarily a signal to short the market or sell your stock positions. 

Action to Take –> As portfolios expand in value on the backs of an extended market upturn, investors need to heed all of the traditional signals. This warning signal is flashing red in tandem with a range of technical indicators that signal overbought conditions. That makes this a fine time to lock in profits on your top-performing picks (while holding firm with your more value-oriented or income-producing portfolio holdings). Raising cash now could help provide the ammo for the next buying opportunity if we see a sharp market pullback.