Tuesday, October 3, 2017

Message to Buffett: Thanks a Million!

Among the various stock market valuation gauges, Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world. The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags the GNP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the S&P 500 price-to-forward-revenues ratio (a.k.a. the price-to-sales ratio), which is available weekly, has been tracking Buffett’s ratio very closely. In an interview with Fortune in December 2001, Buffett said: “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.” That’s sage advice from the Oracle of Omaha.

Buffett’s ratio rose back to 176% in Q2-2017, nearly matching the Q1-2000 peak of 180, and the weekly measure rose to 198% in mid-September. Yet Buffett chose to ignore all that, predicting that the DJIA will be over 1 million in 100 years. He said that on September 19, 2017, speaking at an event in New York City marking the 100th anniversary of Forbes magazine. Buffett noted that 1,500 different individuals have been featured on Forbes’ list of 400 wealthiest Americans since the start of that tally in 1982. “You don’t see any short sellers” among them, he said, referring to those who expect equity prices will fall. He added, “Being short America has been a loser’s game. I predict to you it will continue to be a loser’s game.” Buffett also said, “Whenever I hear people talk pessimistically about this country, I think they’re out of their mind.”

CNBC reported that Mario Gabelli joked on Twitter about whether Buffett’s normally sunny outlook had darkened given the numbers: “one million in one hundred years ... has Buffett turned bearish?,” Gabelli tweeted. He noted that the roughly 3.9% compound annual growth rate (CAGR) needed to get from where the Dow is today to where Buffett predicts it will be in 2117 would be lower than the 5.5% CAGR from the beginning of the 20th century until now. Let’s have a closer look at the numbers:

(1) I have a monthly series for the DJIA starting December 1920. I can put it on a ratio scale and compare it to alternative compounded annual growth rate (CAGR) lines. During the 1950s to 1970s, the DJIA crawled along between CAGR lines of 4%-5%. During the two bull markets of the 1980s and 1990s, it climbed from a CAGR of about 4% at the August 1982 trough to about 6% at the March 2000 peak. During the 2000s and 2010s, it has been rising around the 6% CAGR trend.

(2) Starting from the last trading day of 2016, when the DJIA was at 19,763, I calculate the following DJIA targets in 2117 in round numbers: 54,000 (1% CAGR), 146,000 (2%), 391,000 (3%), 1,038,000 (4%), and 2,729,000 (5%).

(3) Adjusting for inflation, using the CPI since December 1920, the real DJIA has been rising between the 2%-4% CAGR lines averaging around 3%. Since 2000, it’s been tracking the 3% line quite steadily.

(4) All of the above is based on the long-term annualized return of the DJIA ignoring dividends. Nevertheless, it is interesting that the 3.0% real annualized return from net capital gains isn’t far off the 3.3% average real earnings yield of the S&P 500 since 1952. I derived that yield by subtracting the CPI inflation rate from the S&P 500’s earnings-price ratio.