Warren Buffett doesn’t spend a lot of time talking about “the market,” and he certainly doesn’t try to time it. As a “bottom-up” investor that looks at individual companies, that’s not his game.
Or at least that’s what you think. The truth is, Mr. Buffett has had quite a bit to say over the years about “the market.” Buffett is no dummy. He’s well aware that as the market goes, so go the valuations of the vast majority of stocks that make up the market, including his own, Berkshire Hathaway Inc. (NYSE:BRK.A).
I’ll never forget an article he wrote for Fortune in 1999 (see “Mr. Buffett on the Stock Market”). I was a senior in college…and already dreaming of making millions in the stock market. It was the 1990s, and anything ending with “dot com” was an instant goldmine.
When Warren Buffett—a man I considered a hero—had the audacity to say that stock returns going forward would be disappointing, I felt betrayed…even insulted. Clearly the old man had lost his touch.
Naturally, I didn’t listen to the Sage of Omaha…and I lost a lot of money as a result in the crash that quickly followed. It was a lesson well learned.
But Buffett’s words sixteen years ago are every bit as insightful today as they were then. Buffett argued that in order for investors to earn anything close to historical returns in the market the following two conditions would have to hold:
- Interest rates must fall further.
- Corporate profitability in relation to GDP must rise.
In 1999, Buffett considered both of those scenarios unlikely, though he acknowledged that “If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks.”
Well, rates have obviously fallen a lot further than that, and the market hasn’t exactly doubled from 1999 levels. The market is up about 40% from the old dot-com-era high. But Buffett’s point was well made. Lower rates have allowed for much higher stock valuations.
On the second count, corporate profits, the ever-quotable Buffett wrote:
You know, someone once told me that New York has more lawyers than people. I think that’s the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.
Well, so much for that. As you can see in the chart, courtesy of the St. Louis Fed, corporate profits have now nearly doubled the levels that Buffett believed to be unsustainable.