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Rational Market Expectations

Noted investor Warren Buffett rarely predicts the future direction of the stock market. He prefers to focus commentary on his trademark investing style, the analysis of corporate valuations.  But in 1999, in a series of speeches, Mr. Buffett did cross the prediction threshold—and in the process, provided investing insight that is as relative today as it was 10 years ago.  Mr. Buffett reviewed the historical performance of the Dow Jones Industrial Average for the 34-year period that preceded his speech, breaking it into two 17-year segments. His perennial advice?  Govern your market expectations carefully.

 

Segment 1: 1964–1981

During the first 17-year segment, from the end of 1964 through the end of 1981, the Dow Jones Industrial Average (“DJIA”) rose by only 0.88 points, from 874.12 to 875.  It wasn’t because the U.S. economy was underperforming, because gross domestic product (“GDP”) rose by 370% during that period.  So what was the problem?  Interest rates, Mr. Buffett explained.  From 1964 to 1981, the risk-free rate of return—which is generally considered the return of the U.S. Treasury bond—rose from 4% to 15%.  This depressed the stock market, because why would investors buy stocks — which involve risk to your principal and the possibility of a permanent loss of capital — when they can get a similar return from a risk-free investment? Second, after-tax corporate profits as a percentage of GDP fell during the first 17 years to historically low levels.  Investors looked at both of these factors—rising interest rates and low profits — and did what investors tend to do: They projected what they were seeing into the future, and therefore valued the Dow at the same level it was at 17 years earlier.

 

Segment 2: 1982–1998

During the next 17-year period, the situation was drastically different.  From the end of 1981 to the end of 1998, the Dow rose 8,306 points, from 875 to 9181. This increase was historic, surpassing the return you would have realized if you'd bought stocks at their depression-era bottom and held them for 17 years — and it happened even though GDP rose significantly less than it had in the previous 17 years.  How were the second 17 years different?

Interest rates and after-tax corporate profits as a percentage of GDP explain most of the dramatic rise in the Dow, said Mr. Buffett.  The risk-free rate of return fell—from 14% in 1981 to 5% in 1998.  At the same time, after-tax profits as a percent of GDP began to climb, so that by the late 1990’s, they were close to 6%.  Investors could simply obtain a higher potential return by investing in stocks than they could by investing in government bonds.

Additionally, in the second 17 years, another factor also came into play: market psychology.  A bull market got underway, and once that happens, investors tend to get caught up in the moment by following the crowd.

 

The Next 17 years - Buffett Reality Check

When Mr. Buffett spoke in 1999, that bull market continued and investors had rosy expectations for the future.  According to one poll, those who had invested for less than five years expected average annual stock returns of 22.6% over the next 10 years, and those who had invested for more than 20 years expected average annual stock returns 12.9%.  Mr. Buffett argued that wasn’t going to be the case. 

In order for it to happen, he said, two things had to occur.  First, the risk-free rate of return had to fall even further than 5% (making the difference between it and potential equity returns greater, thereby enticing investors into the stock market).  Second, after-tax corporate profits as a percentage of GDP had to rise even further than 6%.  Mr. Buffet was particularly adamant about the second point, arguing that sustained GDP growth of more than 5% is unlikely — and corporate profits as a percentage of GDP could not rise more than GDP itself.  “You cannot expect to forever realize a 12% annual increase—much less 22%—in the valuation of American business if its profitability is growing only at 5%,” he said.  “The inescapable fact is that the value of an asset, whatever its character, cannot over the long-term grow faster than its earnings.”

Mr. Buffett said that if he had to predict the return of equities over the next 17 years, from appreciation and dividends combined, in a world of constant interest rates and 2% inflation, investors in aggregate would earn around 6% per year.

Mr. Buffett ended by countering what he saw as one investor objection — that investors could earn more than 6% by picking the obvious winners.  To that, he reminded his audience of two industries that had transformed the country much earlier in this century: automobiles and aviation.  Both had prospects that would have caused investors to salivate had they been able to see the future.  But, the U.S. automobile industry ended with three major companies, and of 300 aviation companies in existence from 1919 to 1939, only a handful were still in business in 1999.  The point, said Mr. Buffett, is that the key to investing is not determining how much an industry will grow, but determining the competitive advantage of a specific company — and the long-term prospects of that advantage.

 

Posted on Friday, August 26, 2011 at 03:47PM by Registered CommenterRafael Velez in | Comments Off

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