An indicator Buffett favors is sending a warning signal to investors. According to a hedge fund founder, the information in this indicator is clear: U.S. stocks look extremely expensive, so investors need to be cautious.

For those unfamiliar with this concept, the Buffett Indicator compares the value of U.S. stocks to the size of the economy by dividing total U.S. stock market capitalization by gross domestic product (GDP). As early as 2001, Buffett said that this indicator was the "best single measure of where valuations stand at any given moment."

As of early July, this ratio has risen to over 2, reaching a level not seen since early 2022. According to FactSet data, a previous similar situation indicated the worst calendar year decline of the S&P 500 index since 2008.

Doug Kass, founder and president of Seabreeze Partners Management, said: "Nearly two years ago, this ratio rose to an unprecedented level. It should have been a very strong warning signal."

Since Buffett first praised the indicator, known as the Oracle of Omaha, he has been more reserved about his attitude toward it, but investors like Kass still use it to help determine the valuation level of U.S. stocks. The indicator has been quite reliable in the past, predicting major sell-offs in 1987 and 2000, as well as the situation leading up to the financial crisis.

Kass said that generally, when the indicator reaches two standard deviations above its long-term average, investors should start paying attention. And today, it is at this level. Kass said one reason Buffett was initially attracted to the indicator was his skepticism toward indicators that could be easily manipulated.

Currently, the Buffett Indicator is not the only one indicating that stock valuations look overpriced. Other popular valuation indicators, including the past 12-month P/E ratio, P/S ratio, and enterprise value-to-sales ratio, are all in the historical 90th percentile or higher, Kass said.

Like other indicators, the Buffett Indicator has its drawbacks. One issue is that it does not take into account the interest rate factor, with the current federal funds rate at its highest level in over 20 years.

Kass added that it also does not consider the fact that the share of company profits coming from overseas is increasing. He said, "The full picture of an investment is very complex, and no indicator is absolutely reliable."

Another potential complexity today is that a few large stocks have contributed the vast majority of the gains in the U.S. stock market over the past 18 months. This means that the indicator may overlook the fact that many stocks are still relatively cheap compared to history, with only a few stocks being extremely expensive.

According to FactSet data, the S&P 500 index set a new closing high for the 36th time this year on Tuesday. As of the time of writing, the S&P 500 index rose 0.22% to 5589.42.

Edited by Jeffrey