It is Oct. of 2008, Dow is hovering at around 9,000, about where it was 10 years ago. S&P 500 is about 10% lower. If you have been investing an S&P500 index fund, you are losing money even if you have been doing dollar cost average. Where are we with market valuations? What kind of return can we expect from the general market over the next decade?
In his Oct. 16 article on New York Times, Warren Buffett wrote. “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.” He is much more bullish about stocks now. What are the factors that make Buffett more bullish? What returns does he mean by “a substantial degree”?
Before we can answer the question, let’s review what Warren Buffett said before and how he come up with the numbers.
Review of Buffett Speeches and Articles
In Nov. 1999, Dow was at 10,998, a few months before the burst of dotcom bubble, stock market gained 13% a year from 1981-1998, investors’ (or speculators’ rather) expectations were high. The inexperienced investors--those who had invested for less than five years--expected annual returns over the next ten years of 22.6%. Even those who had invested for more than 20 years were expecting 12.9%. Warren Buffett said in a speech to friends and business leaders, “I'd like to argue that we can't come even remotely close to that 12.9%... I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”
We all know what happened afterwards. Two years after the Nov. 1999 article, Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”
9 years has past since the publication of the article of Nov. 22, 1999, it has been a painful and wild ride for most investors. The good news is that Mr. Buffett is now bullish. “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.” He wrote.
Warren Buffett’s key value-determining factors
To understand how Mr. Buffett came up with the numbers, let’s review the factors Mr. Buffett uses to determine the market valuations. His key value-determining factors are:
1. Interest rate.
Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”
2. Corporate profitability in relation to GDP
“5% growth in GDP… it is a limiting factor in the returns you're going to get: 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%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.”
Over time, corporate profitability always reverses back to the mean relative to GDP, Warren Buffett argues. Therefore, over long term, the stock market will only gain as much as the GDP does.
3. You are an optimist
“… who believes that though investors as a whole may slog along, you yourself will be a winner.”
Good luck with that... unless you only buy good companies at under valued prices.
Where are we today with market valuations?
Based on the above assumptions, Mr. Buffett uses the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. “The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.” Warren Buffett said.
With this in mind, we have drawn the ratio of Wilshire Total Market index with regard to GNP. The ratio is shown below. As we can see, the market is valued at the level of 1992-1994, the eve of the unprecedented bull market.
What can we expect from the general market for the next decade?
Two years after the Nov. 1999 article, Dow was down to about today’s level, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”
Mr. Buffett derived his 7% number from the expected GDP growth and the stock market valuations at the time. 6 years has past, Dow is sitting about where it was 6 years ago. This country experienced a recession and maybe in one today. But still the US economy measured by GNP grew 41%. This means that the stock market valuation is sitting about 40% lower than it was when Mr. Buffett projected 7% return in the stock market. If all these numbers are true, we expect that stock market is positioned for a long term annualized return of around 10% a year.
P. S. In our back testing of 1998-2008, we found that highly predictable companies outperformed general market by about 9% a year, undervalued predictable companies beat the market by more than 16% a year. You may want to check our list of predictable companies and Buffett-Munger Screener.