Key Points
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Valuations are soaring, which brings good and bad news for investors.
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Overvalued stocks could pose the greatest risk during a market pullback.
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Warren Buffett warns that some investors may be taking unnecessary risks right now.
The stock market has been on a record-breaking run over the past few years, with the S&P 500(SNPINDEX: ^GSPC), Nasdaq Composite(NASDAQINDEX: ^IXIC), and Dow Jones Industrial Average(DJINDICES: ^DJI) all reaching new heights.
But despite the impressive gains, stock prices can’t continue surging forever. While nobody can predict the market’s short-term movements, it’s only a matter of time before we face another bear market. And according to Warren Buffett, some investors may be in for a rude awakening.
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Warren Buffett warns that some investors are “gambling”
In an interview with CNBC during Berkshire Hathaway‘s annual meeting earlier this year, Buffett offered his thoughts on this historically expensive market.
He noted that he often compares the market to a church with a casino attached — representing slow-and-steady long-term investing and short-term risk-taking. “[T]he casino has gotten very attractive to people,” Buffett warned, going on to emphasize that “that’s not investing, it’s not speculating, it’s gambling.”
Sometimes, the riskiest investments are the ones investors don’t even realize are risky. When the market is booming, it’s increasingly likely that some stocks are overvalued. These stocks can surge in the short term, but they generally correct themselves over time.
Even more dangerous are the hype-fueled investments that have little substance to back up their soaring stock prices. We’ve already seen this play out with the dot-com bubble, when many tech companies broke IPO records only to go bankrupt a few years later when the market collapsed beneath them.
The stock market has a warning of its own
With company valuations soaring, the broader market itself is also becoming more expensive. The S&P 500 Shiller CAPE ratio is a valuation metric that tracks the index’s inflation-adjusted earnings over the last decade.
A higher ratio suggests that the market is trading at a premium, and historically, stock prices tend to fall in the years following a peak. Since 1871, the S&P 500 Shiller CAPE Ratio has averaged around 17. It hit an all-time high of 44 in 1999, just before the dot-com bubble popped, and it’s now surpassed 40 again for only the second time in history.
S&P 500 Shiller CAPE Ratio data by YCharts
So, does this mean we’re in a stock market bubble? Not necessarily.
The market landscape has transformed significantly over the past two decades, and higher valuations don’t automatically indicate a stock is overvalued. If the artificial intelligence (AI) boom — which has fueled much of the market’s returns over the last few years — contributes to meaningful economic growth, these higher valuations may be justified.
The risk to investors, though, is that there are plenty of overvalued stocks hidden among the fairly valued companies. Invest in the wrong stocks, and your portfolio could face a steep decline during the next bear market.
No matter what may be coming for the market, the best move you can make right now is to ensure you’re only investing in healthy stocks with robust underlying business fundamentals. Strong companies may still experience short-term volatility, but they’re far more likely to thrive over the long haul.
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Katie Brockman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.