Monday, August 23, 2010

Buffett on the Stock Market

I think the following makes the truly excessive focus on the next economic indicator by business media, analysts, and others look kinda silly.

It's well established that Buffett does not believe attempting to time or predict the market is wise or even possible. Yet, in the past, he has been willing to articulate what he believes are the economic and psychological forces that determine stock prices. Here's one example. In 2001 he had this to say in Fortune about the stock market.

The last time I tackled this subject, in 1999, I broke down the previous 34 years into two 17-year periods*, which in the sense of lean years and fat were astonishingly symmetrical. Here's the first period. As you can see, over 17 years the Dow gained exactly one-tenth of one percent.

Dow Jones Industrial Average
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00

And here's the second, marked by an incredible bull market that, as I laid out my thoughts, was about to end (though I didn't know that).

Dow Jones Industrial Average
Dec. 31, 1981: 875.00
Dec. 31, 1998: 9181.43

Now, you couldn't explain this remarkable divergence in markets by, say, differences in the growth of gross national product. In the first period--that dismal time for the market--GNP actually grew more than twice as fast as it did in the second period.

Gain in Gross National Product
1964-1981: 373%
1981-1998: 177%

So what was the explanation? I concluded that the market's contrasting moves were caused by extraordinary changes in two critical economic variables--and by a related psychological force that eventually came into play.

Here I need to remind you about the definition of "investing," which though simple is often forgotten. Investing is laying out money today to receive more money tomorrow.

That gets to the first of the economic variables that affected stock prices in the two periods--interest rates. In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you're going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.

So here's the record on interest rates at key dates in our 34-year span. They moved dramatically up--that was bad for investors--in the first half of that period and dramatically down--a boon for investors--in the second half.

Interest rates, Long-term government bonds
Dec. 31, 1964: 4.20%
Dec. 31, 1981: 13.65%
Dec. 31, 1998: 5.09%

The other critical variable here is how many dollars investors expected to get from the companies in which they invested. During the first period expectations fell significantly because corporate profits weren't looking good. By the early 1980s Fed Chairman Paul Volcker's economic sledgehammer had, in fact, driven corporate profitability to a level that people hadn't seen since the 1930s.

The upshot is that investors lost their confidence in the American economy: They were looking at a future they believed would be plagued by two negatives. First, they didn't see much good coming in the way of corporate profits. Second, the sky-high interest rates prevailing caused them to discount those meager profits further. These two factors, working together, caused stagnation in the stock market from 1964 to 1981, even though those years featured huge improvements in GNP. The business of the country grew while investors' valuation of that business shrank!

And then the reversal of those factors created a period during which much lower GNP gains were accompanied by a bonanza for the market. First, you got a major increase in the rate of profitability. Second, you got an enormous drop in interest rates, which made a dollar of future profit that much more valuable. Both phenomena were real and powerful fuels for a major bull market. And in time the psychological factor I mentioned was added to the equation: Speculative trading exploded, simply because of the market action that people had seen.

Things like growth in GDP reveal little about the future of the stock market though the daily obsession with the latest economic indicator may make some feel otherwise. Better to have some skepticism the next time anyone implies a strong correlation. Most macro factors mean very little in the context of successful long-term equity investing.

The initial price of a stock relative to its intrinsic value, growth in that value driven by profitability, future interest rates, and psychological factors are what determine future prices. Being able to see upfront the mispricing of an individual securities (usually when the micro and macro news is bad) and avoiding the mistake of projecting forward recent economic and investing experience make a huge difference.

Experience cannot be informed by a short historical perspective.

In 1999 many were projecting forward, incorrectly, the experience of the 1980s and 1990s bull markets into the 2000s. Any recent experience in the collective psyche of investors can help cause mispricing of individual securities. Knowing history is smart but it needs to cover a sufficiently long time frame.

Otherwise, what's recently been in the rear-view mirror distorts expected future outcomes.


* Art Cashin makes reference to the 17.6 Year Market Cycle in this previous post.
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