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Warren Buffett's Favorite Indicator Shows Equities May Be Stretched

Stocks in this article: SPY XHB IWM

NEW YORK (TheStreet) -- U.S. equity markets are reaching valuations relative to economic output not seen since the turn of the millennium, which could leave investors -- including Warren Buffett -- searching for safety in the months to come.

Gross domestic product expanded at a 4% annual rate as activity picked up broadly after shrinking at a revised 2.1% pace in the first quarter, the Commerce Department said on Wednesday.

Read More: Jobs and the Economy: What Today's Numbers Mean

Growth in the second quarter was driven mainly by consumer spending and an upswing in business inventories. Consumer spending growth, which accounts for over two-thirds of U.S. economic activity, grew at a 2.5% pace, as Americans consumed more durable goods and services.

SPDR S&P 500 (SPY) traded flat on the news as the market keeps an eye on commentary from the Federal Reserve later in the day and employment numbers on Friday. The overall level of equity markets relative to economic output, however, is reaching heights that may justify the idea that valuations are a bit "stretched."

The indicator below shows the price action of the S&P 500 Index relative to real U.S. GDP, which can be compared to a price-to-earnings ratio. The only difference is that this indicator measures a broad U.S. equity index relative to all of the inflation-adjusted earnings in the economy.

Warren Buffett has been quoted as saying that this indicator is "probably the best single measure of where valuations stand at any given moment," according to an interview he did with Fortune magazine in 2001.


Read More: U.S. Growth Surge Intensifies the Great Interest Rate Debate

The current measure has slightly surpassed highs not seen since spring of 2000. Even before the market crash during the financial crisis, equity markets had not yet reached its past valuation highs.

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