Is This Buffett's Ultimate Buy Signal?

Just admit it: You want to know when Warren Buffett thinks it's time to buy stocks.

Of course, regular readers of The Motley Fool know that we're more obsessed with Buffett than most. As far as Buffett "indicators" go, earlier this year I jumped on "unleveraged net tangible assets," which Buffett mentioned in his most recent letter to Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) as a sign of a great business. Last month, my fellow Fool Morgan Housel noted that the market's sell-off was starting to make the market look attractive on the basis of another Buffett indicator.

Now, thanks to a voice from the past, I've got another indicator to add to your investing tool belt with the Warren-Buffett-face buckle (wait, you mean I'm the only one with that?).

Buffett putting his foot down
It's not all that often that Buffett grabs the microphone and makes a strong, specific call on the stock market. Back in late 1999, the tally of Buffett's calls was at six. Total. At least according to noted value investor Whitney Tilson.

At the time, Tilson was writing for The Motley Fool, and in November 1999 he outlined the six calls that Buffett had made. I'll review them briefly here.

  1. 1968. At this time Buffett -- still running his private investment partnership -- started griping about how he was having trouble finding "first-class investment ideas" and he held onto that view through the much of 1974. Measure from June 1968 to October 1974, the S&P 500 fell 37%. For the decade starting in June 1968, the S&P lost 2.6%.

  2. 1974. Buffett changed his tune as the market fell and in late 1974 he made his famous comment that he felt like "an oversexed man in a harem" -- meaning simply that he was awash in investment opportunities. The S&P 500 rose 11% per year over the next five years and 10% per year over the next decade.

  3. 1979. The market dived between 1977 and 1979 and investors started getting cold feet again. Not Buffett. He told Forbes that stocks were still the way to go. The S&P 500 returned 9% over the next five years and 13% over the next 10.

  4. 1986. This begins a period when investors might have understandably lost faith in the wisdom of ol' Buffett because stocks were expensive and simply got even more expensive. At the Berkshire annual meeting in 1986, Buffett said he was having trouble finding bargains. Though he would have steered clear of the 1987 market crash, for the five and 10 years starting in mid-1986 annual returns were 10% and 11%, respectively.

  5. 1992. In Berkshire's 1992 annual report, Buffett wrote that he and Charlie Munger were "virtually certain that the return over the next decade from an investment in the S&P index will be far less than that of the past decade." He was more or less right there. For the decade ending in 1992 annual S&P returns were 12%, while the following decade they were 8%. However, many investors -- particularly today -- wouldn't sneeze at 8% per year.

  6. 1999. Writing in November of 1999, Buffett cautioned investors about the stock market and suggested that optimism was wildly high. He predicted that real stock market returns over the ensuing 17 years would be in the 4% range. He added "And if 4% is wrong, I believe that the percentage is just as likely to be less as more." We all know how that's worked out so far.

Dedicated Buffett watchers know that we can add one more to this list. In late 2008, Buffett penned in op-ed for The New York Times -- "Buy American. I Am." -- in which he put his foot down for U.S. stocks. It's a little early to call the success of that one, but the S&P 500 is currently up 23% from that point.

Back to that indicator
Sifting through market data around the times that he made those calls, I noticed a common thread. Every time Buffett gave stocks the thumbs up, the inverse of Professor Robert Shiller's cyclically adjusted price-to-earnings ratio -- or CAPE -- was greater than the yield on a long-term Treasury. When Buffett wasn't crazy about stocks, the opposite was true.

Now if that seems a convoluted and odd way to look at it, let me explain. Shiller's CAPE is simply a longer-time-horizon version of the much-watched price-to-earnings ratio. Instead of using just single-year earnings, the CAPE uses average earnings over a 10-year period. And if we flip either the single-year P/E or the CAPE on its head, what we get is an earnings yield for the stock market, which gives us a way to compare it to bonds.

When we stack the CAPE yield against bonds, it would logically follow that stocks are the way to go when the CAPE yield is higher and bonds are a better stash spot for your money if the bond yield is higher.

To be fair, I'm a little doubtful that Buffett is looking at this in particular, but I do think it's a good way to gauge how he might be thinking. CAPE is a long-term gauge and Buffett is a long-term kind of guy. It also highlights the yield difference between two of the primary investment pools that Buffett can put money to work in.

The good news for investors? With markets recently sliding while Treasury rates continue to drop, this indicator suggests stocks are a solid buy today.

The fine print
It's key to remember that we're talking comparative returns here. Just because stocks look good in comparison to bonds doesn't mean that they'll make you fabulously rich over the next few years. With 10-year Treasuries currently yielding under 2%, there's a fantastically low bar for stocks to hurdle to make them look attractive.

To the same point, in his 2008 op-ed, Buffett didn't say that stocks were about to soar. In fact, he spent a few paragraphs simply talking about how investors are better off owning stocks than holding cash. That's not exactly a raging bull call.

Of course, as I like to point out, there are currently a lot of individual stocks that you can find with much better potential returns than the broader market. Many of these are large, high-quality companies that you can find in Buffett's portfolio. Focusing on the one-year earnings yield (the inverted P/E), major Buffett holdings Wells Fargo (NYS: WFC) and ConocoPhillips (NYS: COP) have yields above 10%. Fellow Berkshire holdings Procter & Gamble (NYS: PG) and Johnson & Johnson (NYS: JNJ) have respective dividends of 3.4% and 3.6% -- both well above Treasury rates.

You may not have the decades of experience that Buffett does, his uncanny natural ability, or the billions in investable assets, but keeping an eye on the numbers that he's likely tuned into can help get you pointed in the right direction. And if you're looking for more potentially Buffett-esque stocks, check out these five stocks that the Motley Fool owns -- and thinks you should, too.

At the time thisarticle was published The Motley Fool owns shares of Johnson & Johnson and Berkshire Hathaway. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, Procter & Gamble, and Berkshire Hathaway, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway and Johnson & Johnson, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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