Mr. Buffett on the Stock Market
A look back at Warren Buffett's warning about elevated stock valuations in 1999 and the potential application of his ideas to valuations today.
In November 1999, Carol Loomis published an article in Fortune based on several informal talks that Warren Buffett had given earlier in the year to groups of his friends. Mr. Buffett made a compelling argument warning investors to curb their enthusiasm for future returns from stocks. I used to read Fortune cover-to-cover and this article had a major impact on my outlook for the future.
A quarter century is nothing in the context of human history, but it is a very long time compared to a human lifespan. Investors old enough to have had meaningful exposure to the stock market of the late 1990s are at least in their fifties today while those who were in senior roles are mostly retired. Young investors now think of the late 1990s in the same way that I thought of the Nifty Fifty bubble of the late 1960s and early 1970s.
Warren Buffett is normally unwilling to discuss the valuation of the stock market or to make predictions but he felt the need to make an exception in 1999.
He felt that expectations had risen to such a high level that there was virtually no chance that long-term returns could match what people were planning on. I think he felt a duty to warn his friends in private talks and, probably at the urging of Carol Loomis, agreed to publish his concerns for a wider audience.
There is no doubt that expectations were elevated in late 1999:
“Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A Paine Webber and Gallup Organization survey released in July  shows that the least experienced investors — those who have invested for less than five years — expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%.
Now, I’d like to argue that we can’t come even remotely close to 12.9%, and make my case by examining the key value-determining factors.”
Mr. Buffett goes on to explain his rationale and argue that those who are expecting double digit returns need to justify their assumptions for the underlying factors that he describes. He stressed that he was not predicting what the market would return over short periods like a few months or a year but was looking out over a decade.
More than enough time has passed to conclude that Mr. Buffett was correct about the overall level of the stock market in 1999. Investors who expected double digit returns from the overall stock market were badly disappointed. However, my motivation is not to just confirm that Mr. Buffett was correct in 1999. After I review his rationale for making a bearish long term prediction a quarter century ago, I’ll go on to consider whether a similar warning is justified based on where the same factors stand today.
While I will outline what I view as the essence of Mr. Buffett’s argument, I highly recommend reading his article before proceeding.
To set the stage for his argument, Mr. Buffett begins by observing that the previous thirty-four years could be divided into “an almost Biblical kind of symmetry, in the sense of lean years and fat years.”
From December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average advanced from 874.12 to 875.00. During the same seventeen year period, GDP of the United States rose by 370% while the sales of the Fortune 500 more than sextupled. While investors would have collected dividends during these seventeen years, the price level of the Dow went exactly nowhere.
From December 31, 1981 to December 31, 1998, the Dow Jones Industrial Average advanced from 875.00 to 9181.43. Using a slightly different date range, Mr. Buffett writes that investing $1 million in the Dow on November 16, 1981 would have grown to $19,720,112 by December 31, 1998 assuming reinvestment of dividends. Carol Loomis noted that the Dow had advanced even further to 11,194 by the date of Warren Buffett’s first talk in July 1999.
Obviously, the investor starting out in 1965 had a very different experience in stocks than the equity investor starting out in 1982. This is due to important macroeconomic factors at work during these years that represented a massive headwind in the first period and a strong tailwind in the second. The purpose of Mr. Buffett’s article is to provide an explanation for the radically different performance of stocks during these seventeen year periods, putting into context what seems like a wild situation.
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The level of interest rates has a major influence on the valuation of all investments.