On Jan. 2, the first trading day of the new year, Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial) CEO Warren Buffett (Trades, Portfolio)’s favorite market indicator stood at 123.6%, down approximately 24.9% from the all-time high of 148.5% and 2.8% from Jan. 3, 2017’s reading of 126.4%. Based on this market level, the U.S. stock market is expected to remain flat over the next eight years.
Dow wobbles on first trading day of the new year, yet closes slightly higher
Despite trading over 400 points lower at the intraday low, the Dow Jones Industrial Average closed at 23,346.24, up approximately 18.78 points from the previous close of 23,327.46 on New Year’s Eve.
Several of Buffett’s top bank holdings, which include Bank of America Corp. (BAC, Financial), Goldman Sachs Group Inc. (GS, Financial) and JPMorgan Chase & Co. (JPM, Financial), closed at least 1% higher for the day.
A recap of the Buffett indicator over a volatile two years
As pointed out by Buffett, the ratio of the Wilshire 5000 full cap index to the gross domestic product probably represents the “best single measure” of market valuations at a given time period. Figure 1 illustrates the historical ratio of the market cap and the implied market return over the past two years.
Figure 1
As we can see in Figure 1, the Buffett indicator gradually increased from approximately 126% in 2017 to a two-year high of approximately 147% around August to September 2018. The Buffett indicator then plunged below 125% in late December as investors grappled with fears of an economic slowdown: according to IHS Market data, the purchasing manufacturer’s index (PMI) for the eurozone in December was 51.4, near the lowest level since February 2016, while the PMI for the U.S. slipped to a 15-month low. CNBC columnists Fred Imbert and Sam Meredith added such information represents “a sign of a global slowdown,” according to Art Cashin.
However, markets usually do not exactly reverse to the mean over the next eight years. Thus, we considered the implied market return if the Buffett indicator averages between 40%, 80% and 120% over the eight-year period. According to the predicted and actual returns chart, the expected market return ranges from approximately -7.90% per year in the most pessimistic case to approximately 4.90% in the most optimistic case.
Shiller price-earnings ratio also falls from all-time high
Yale professor Robert Shiller offered an alternative ratio: the cyclically-adjusted price-earnings ratio. The market Shiller price-earnings ratio is currently 27.6, approximately 63.3% higher than the historical mean of 16.9 yet down approximately 15.34% from September’s high of 32.6. Based on the current Shiller valuation, the U.S. stock market is expected to return -0.7% per year over the next eight years.
Just like what we did with the Buffett indicator, we also detail the range of implied market returns if the Shiller price-earnings ratio trends between 50% and 150% of the median. The implied market returns range from -8.5% per year in the most pessimistic case to 4.2% per year in the most optimistic case.
Our model strategies are still outperforming the benchmark despite the hard final month of 2018
We are pleased to announce we have rebalanced our model portfolios for the new year. The top-performing model portfolios include the most broadly held portfolio, the Buffett-Munger portfolio and the undervalued predictable portfolio. Even though the portfolios returned -4.55%, -3.63% and -6.07% for 2018, all three portfolios still outperformed the Standard & Poor’s 500 index return of -6.24%. Over the past 10 years, the portfolios had an annualized return of 13.07%, 10.76% and 12.54%, all outperforming the benchmark's annualized return of 10.40%.
Disclosure: No positions.
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