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The 'Buffett Yardstick' may be signaling the worst risk-reward setup ever

MarketWatch logo MarketWatch 6/12/2019 Shawn Langlois
IN ONE CHART
Warren Buffett wearing glasses and smiling at the camera © Getty Images Warren Buffett

Warren Buffett of Berkshire Hathaway (BRK) says it’s “probably the best single measure of where valuations stand at any given moment.”

The “Buffett Yardstick,” as longtime money manager Jesse Felder of the Felder Report calls it, plots the total value of the stock market against the overall size of the economy. What makes it so valuable, he says, is that it’s good at telling investors what to expect from equities going forward.

So what’s it telling them now?

Felder put the “Yardstick” (inverted) up against forward 10-year returns in the stock market in the chart below to create what he describes as the best representation of one of his favorite Buffett quotes: “The price you pay determines your rate of return.”

a close up of a map

According to this measure, Felder says investors are paying such a high price for stocks that they are likely to receive basically nothing in return in the coming decade, and that includes dividends.

“At the same time that potential returns look so poor, the potential for risk may be greater than it has been in generations,” he wrote, pointing out that investors have been piling on margin debt lately to increase their exposure to an overheated market.

a close up of a map

Comparing this rising margin debt to the size of the economy, Felder says, shows that investors haven’t been this greedy since 1929.

“All of this leveraged speculation must at some point be unwound, usually via forced selling during a bear market,” he wrote. “The last two times it came even close to the current level the stock market suffered 50% declines.”

Felder warned that this time around, the pieces are in place for an even bigger drop. “In all, long-term investors are risking roughly a 60% decline to try to capture a 0% rate of return over the coming decade in the stock market, one of the worst risk-to-reward setups in history,” he wrote in a blog post.

In Wednesday’s trading session, the Dow Jones Industrial Average (DJIA), S&P 500 index (SPX) and Nasdaq (COMP) were all moving lower.

Related video: The life-changing lesson Warren Buffett taught me at a dinner party (provided by CNBC)

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