Should You Buy Stocks After The Recent Market Sell-Off? Here's What One of Warren Buffett's Favorite Valuation Gauges Says.

Stocks have whipsawed this year, as weak economic data, high valuations, and issues around tariffs have confused investors. After everything that's happened in just a few short months, the broader benchmark S&P 500 finds itself down about 9% on the year as I write this, although it's down much more if you look at highs made in the back half of February. This may leave investors wondering if they should buy the dip after the sell-off.

Many stocks haven't been this cheap in quite a while, but the saga with tariffs and rising tensions with China makes the environment anything but certain. If you're looking for answers on whether to invest, you can check one of Warren Buffett's favorite valuation gauges.

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What the Buffett indicator tells investors

Buffett has been investing successfully for decades, and his company, Berkshire Hathaway, has widely outperformed the broader market since 1965. While Buffett and his team have never been afraid to adapt, they are also very disciplined and aren't going to pour money into stocks when they think the market is overvalued. They also won't be afraid to buy stocks when there is a market crash. Berkshire made some great investments during the Great Recession and during the early days of the COVID-19 pandemic.

One metric that Buffett came up with has since been dubbed the Buffett indicator, which divides the market cap stocks in the U.S. by the country's gross domestic product (GDP). A common approach for the United States is to look at the Wilshire 5000, which attempts to measure the market cap of all U.S. equities. In a 2001 Fortune article, Buffett called this indicator "probably the best single measure of where valuations stand at any given moment."

According to data site longtermtrends.net, the ratio was around 177% as of April 12, down from a peak of over 200% earlier this year, but still above the area where Buffett would find the market attractive. Buffett has previously said that the market is most attractive when the Buffett indicator is in the 70% to 80% range. When the ratio is near 200% or higher, a scenario that occurred right before the dot-com bubble, that indicates a very risky environment.

Still, it's important to note that the Buffett indicator hasn't been below 100% since 2013, and the U.S. economy and the stock market have changed significantly over the years. For instance, interest rates were extremely low between 2009 and 2022. Since the Great Recession, the Federal Reserve has also pumped trillions of dollars into the economy through quantitative easing, which many believe has led to assets being inflated.

The Fed also injected trillions into the economy during the worst of the COVID-19 pandemic. While the agency has started to reduce its balance sheet, it's still quite bloated. Additionally, retail investors have become much more active through digital brokerages, zero-commission trading, and the rise of exchange-traded funds (ETFs), which has increased access and liquidity.

Is now a good time to buy stocks?

If you're looking at the Buffett indicator through a traditional lens, the popular valuation gauge says that U.S. stocks are still very much overvalued. However, as I pointed out, a lot has changed over the years, and the Buffett indicator hasn't read below 100% in over a decade. I certainly think there could be more room to fall for stocks in the near term. Uncertainty among investors is still high, and we don't know how the tariff situation and negotiations between the U.S. and China will play out.

If you feel stressed and would prefer to sit in cash for a bit longer, there's nothing wrong with that. But I think investors can always buy stocks, as long as they have a long-term investing horizon and understand that volatility could be high in the near term. I'd recommend dollar-cost averaging, where you automatically invest the same amount of money over regular intervals, which helps smooth out the cost basis and ensures you're not investing based on emotion.

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Bram Berkowitz 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.