Money and Finance
- John Mauldin: Forecast 2014: The Capes Of Hope
Link to: Forecast 2014: The CAPEs of HopeLast week's letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller's cyclically adjusted price-to-earnings...
- Stocks As Overvalued Now As At 2007 High - By Mark Hulbert
Here’s yet another reason to be worried about the stock market: A valuation model with an impressive record says that stocks are as overvalued today as they were at the 2007 stock market peak. The model comes from Dan Seiver, a member of the economics...
- Fight The Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, And Future Returns - By Cliff Asness (december 2002)
Abstract: The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional...
- Barron's Interviews - Howard Marks And Rob Arnott
From November and December. Interestingly, they both mentioned convertible bonds as an attractive area right now.-Interview with Howard Marks (11/17/2008):-What went wrong with risk management?- First of all, you need a risk manager who knows the business...
- Ultra High Yield = Ultra High Risk
The first rule of dividend investing (or at least it should be the first rule) is: If the yield is too good to be true, it probably is. In an article I wrote last May, I looked into the highest-yielding stocks on the UK FTSE All-Share and found that...
Money and Finance
Fortune: December 2001 - Warren Buffett on the Stock Market
It's always a decent time to go back and read Mr. Buffett's old thoughts, but now is probably a better time than most.
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To break things down another way, we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points.
How could this have happened? In a flourishing country in which people are focused on making money, how could you have had three extended and anguishing periods of stagnation that in aggregate --leaving aside dividends-- would have lost you money? The answer lies in the mistake that investors repeatedly make--that psychological force I mentioned above: People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them.
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Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience --a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.
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Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale.
By my thinking, it was not hard to say that, over a 20 -year period, a 9.5% bond wasn't going to do as well as this disguised bond called the Dow that you could buy below par--that's book value--and that was earning 13% on par.
Let me explain what I mean by that term I slipped in there, "disguised bond." A bond, as most of you know, comes with a certain maturity and with a string of little coupons. A 6% bond, for example, pays a 3% coupon every six months.
A stock, in contrast, is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect "coupons." The set of owners getting them will change as shareholders come and go. But the financial outcome for the business' owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about.
Now, gauging the size of those "coupons" gets very difficult for individual stocks. It's easier, though, for groups of stocks. Back in 1978, as I mentioned, we had the Dow earning 13% on its average book value of $850. The 13% could only be a benchmark, not a guarantee. Still, if you'd been willing then to invest for a period of time in stocks, you were in effect buying a bond--at prices that in 1979 seldom inched above par--with a principal value of $891 and a quite possible 13% coupon on the principal.
How could that not be better than a 9.5% bond? From that starting point, stocks had to outperform bonds over the long term. That, incidentally, has been true during most of my business lifetime. But as Keynes would remind us, the superiority of stocks isn't inevitable. They own the advantage only when certain conditions prevail.
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The tour we've taken through the last century proves that market irrationality of an extreme kind periodically erupts--and compellingly suggests that investors wanting to do well had better learn how to deal with the next outbreak. What's needed is an antidote, and in my opinion that's quantification. If you quantify, you won't necessarily rise to brilliance, but neither will you sink into craziness.
On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows 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. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen.
For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire.
How could this have happened? In a flourishing country in which people are focused on making money, how could you have had three extended and anguishing periods of stagnation that in aggregate --leaving aside dividends-- would have lost you money? The answer lies in the mistake that investors repeatedly make--that psychological force I mentioned above: People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them.
…
Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience --a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.
…
Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale.
By my thinking, it was not hard to say that, over a 20 -year period, a 9.5% bond wasn't going to do as well as this disguised bond called the Dow that you could buy below par--that's book value--and that was earning 13% on par.
Let me explain what I mean by that term I slipped in there, "disguised bond." A bond, as most of you know, comes with a certain maturity and with a string of little coupons. A 6% bond, for example, pays a 3% coupon every six months.
A stock, in contrast, is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect "coupons." The set of owners getting them will change as shareholders come and go. But the financial outcome for the business' owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about.
Now, gauging the size of those "coupons" gets very difficult for individual stocks. It's easier, though, for groups of stocks. Back in 1978, as I mentioned, we had the Dow earning 13% on its average book value of $850. The 13% could only be a benchmark, not a guarantee. Still, if you'd been willing then to invest for a period of time in stocks, you were in effect buying a bond--at prices that in 1979 seldom inched above par--with a principal value of $891 and a quite possible 13% coupon on the principal.
How could that not be better than a 9.5% bond? From that starting point, stocks had to outperform bonds over the long term. That, incidentally, has been true during most of my business lifetime. But as Keynes would remind us, the superiority of stocks isn't inevitable. They own the advantage only when certain conditions prevail.
…
The tour we've taken through the last century proves that market irrationality of an extreme kind periodically erupts--and compellingly suggests that investors wanting to do well had better learn how to deal with the next outbreak. What's needed is an antidote, and in my opinion that's quantification. If you quantify, you won't necessarily rise to brilliance, but neither will you sink into craziness.
On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows 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. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen.
For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire.
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Current value of U.S. stocks (8,519.05) / (Real) GNP (estimated at 12,350) = 69%. I'm not exactly sure if those are the same numbers Buffett uses (if someone else does, let me know) because when using the October 2001 numbers Buffett mentions in the article, I get a Wilshire 5000 value of 9,796.90 divided by a Real GNP number of 9,983.10 = 98%. If I use the October GNP number but the December 7th (last trading day before the article was published) Wilshire value of 10,745.40, we get 108%; both well below the 133% mentioned in the article. So I'm either using the wrong current numbers and data points or backtracking incorrectly. Interestingly, the Wilshire's high was reached on October 9, 2007 at 15,806.69. The Real GNP at the end of October 2007 was 11,799.10, for a market value / GNP of 134%. Here's to hindsight!
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Also, Nick's Rational Angle post listed below mentions the 'Stock Market Capitalization as a Percentage of Nominal GDP' number that Prem Watsa has used in his presentations (average over time is just under 60% -- 2008 started at about 110%).
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Related previous posts:
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Mr. Buffett on the Stock Market - 1999 Article from FORTUNE
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Buy American. I Am. - By WARREN E. BUFFETT
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Warren Buffett's 4 Market Call Articles
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GMO: Quarterly Letter – Jeremy Grantham
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Related post from Nick at Rational Angle:
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Stock Market Capitalization to GNP Ratio
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- John Mauldin: Forecast 2014: The Capes Of Hope
Link to: Forecast 2014: The CAPEs of HopeLast week's letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller's cyclically adjusted price-to-earnings...
- Stocks As Overvalued Now As At 2007 High - By Mark Hulbert
Here’s yet another reason to be worried about the stock market: A valuation model with an impressive record says that stocks are as overvalued today as they were at the 2007 stock market peak. The model comes from Dan Seiver, a member of the economics...
- Fight The Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, And Future Returns - By Cliff Asness (december 2002)
Abstract: The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional...
- Barron's Interviews - Howard Marks And Rob Arnott
From November and December. Interestingly, they both mentioned convertible bonds as an attractive area right now.-Interview with Howard Marks (11/17/2008):-What went wrong with risk management?- First of all, you need a risk manager who knows the business...
- Ultra High Yield = Ultra High Risk
The first rule of dividend investing (or at least it should be the first rule) is: If the yield is too good to be true, it probably is. In an article I wrote last May, I looked into the highest-yielding stocks on the UK FTSE All-Share and found that...