Wednesday, September 10, 2014

Buffett on Market Valuation

I don't really spend too much time on market valuation, but I do think about it and post about it every now and then.  Of course, debate about market valuation is pretty heated these days due to the super-high looking Shiller p/e ratio, high profit margins etc.

I was reading through some old Buffett annual reports and found a great primer on how Buffett thinks about stock market valuation so I thought I'd post it here.  This is similar to what used to be called the Fed model (earnings yield = 10 year treasury yield).  The Fed model has been criticized because it only worked for a very brief period (back in the 1980's) and hasn't worked most of the time.  (Earlier this year I skimmed through all of Buffett's partnership and BRK annual letters to find comments related to the stock market, but I am now rereading all the annual letters from 1965-2012 again slowly, word-for-word).

But we can see that Buffett does in fact think about stocks using a similar approach.  And this makes sense because there is a rational reason why earnings yield can be fairly compared to treasury bond rates.  This is not to say that the stock market will always trade at parity with bond yields (history shows that it doesn't).

This may be relevant now to understand why some people like Buffett keep saying the market is trading in a "zone of reasonableness" while some charts show the market to be way out in terms of historical valuation.

And yes, we do understand that Buffett's comments make sense when you think about where interest rates are today (he does keep saying that stocks are better than bonds).

Anyway, this is a long clip but well worth reading almost as a primer on stock valuation, inflation etc.

From the 1981 Berkshire Hathaway letter to shareholders:

Equity Value-Added

     An additional factor should further subdue any residual enthusiasm you may retain regarding our long-term rate of return. The economic case justifying equity investment is that, in aggregate, additional earnings above passive investment returns - interest on fixed-income securities - will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital. Furthermore, the case says that since the equity capital position is associated with greater risk than passive forms of investment, it is "entitled" to higher returns. A "value-added" bonus from equity capital seems natural and certain.
     But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a "good" business - i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.

     Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were "good" businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial.

     That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

     During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.

     Thus, with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. (If the business is owned by pension funds or other tax-exempt investors, the arithmetic, although still unenticing, changes substantially for the better.) Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this is written.

     If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder. Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.

     Unless passive rates fall, companies achieving 14% per year gains in earnings per share while paying no cash dividend are an economic failure for their individual shareholders. The returns from passive capital outstrip the returns from active capital. This is an unpleasant fact for both investors and corporate managers and, therefore, one they may wish to ignore. But facts do not cease to exist, either because they are unpleasant or because they are ignored.
     Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently "bad" businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.

     It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.

     Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically "bad" would be restored to the "good" category under such circumstances.
     A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the "bad" business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings - no matter what penalty such a policy produces for shareholders.

     Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity, does not take the coupons from that bond and pay one hundred cents on the dollar for more 5% bonds while similar bonds are available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-return bond and - if inclined to reinvest - looks for the highest return with safety currently available. Good money is not thrown after bad.

     What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - "wicked and slothful" - but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30)

     But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the "bad" business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

     For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

     Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or "real" dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of "dividends" that can be paid out only if someone promises to replace the capital distributed.)

     Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone's control or from poor relative adaptation on our part.

What Would He Say Now? 
So here are current interest rates:

                  U.S. Treasuries                 Munis
10 year           2.5%                              2.2%
30 year           3.3%                              3.1%

Buffett said that stocks should have higher returns than passive, fixed investments.  Actually, he said that that is the economic justification for investing in stocks.  He didn't say that stock returns should equal fixed income investment returns; just that it should be higher.  So we can see the earning yield - bond yield parity model as the upper limit of stock market valuation.

According to this idea the stock market would have to get up to 30-40x p/e (using the pretax U.S. treasury yield for 10 and 30 years) before it starts to look like stocks aren't worth it.

Using Buffett's tax-equivalent model, assuming 20% long term capital gains and qualified dividend tax rates and 3.1% muni yield, the equivalent earnings hurdle for stocks would be 3.9%; this implies a p/e ratio of 26x.   Using the 10 year muni rate you'd get 36x p/e.  Again, this would be the upper end of a valuation range, not the fair value.

(It's kind of stunning to think that Buffett, in 1981, seemed to be saying stocks aren't worth 7x p/e but says they are reasonably valued now (or at least he said so relatively recently)).

That's silly.  I've seen charts showing the differential between earnings yield and interest rates to show how relatively attractive stocks are.   Those charts do imply that stocks can get to 30-40x p/e and I certainly hope stocks don't get up there.   It probably shows more how expensive bonds are.

Buffett has said that bonds are in a big bubble and is unsustainable (even though I still suspect, because of my having watched Japan post-bubble, that rates will stay a lot lower for a lot longer than most people think).

So if bond rates are unnaturally low due to central bank activity, what is a more natural level of interest rates?

Tangent on No-brainers
What's a post on this blog without an off-topic tangent?  Speaking of interest rates, one of the big no-brainers for 2014 was that interest rates would go up due to "tapering".  The Fed has been buying truckloads of treasuries every month for so long, if they reduced their purchases interest rates will go up.  Simple supply and demand.  It's the easiest trade in the world.  You would have to be stupid not to understand that.  Oops.

I remember a very similar trade when people thought treasuries would crash at the end of QE1 (or QE2, I can't keep track).  The no-brainer trade then was the same; everyone knew that the Fed would stop buying bonds (to the exact date), and everyone knew that this would disrupt supply and demand, and it was obvious that bonds had to decline dramatically.  Oops.  (Bonds rallied dramatically on a collapsing Europe)

One of my early posts on this blog was about gold (Ungold), and gold was a no-brainer too back in 2011.  If the economy recovers, inflation would soar and so would gold.  If the economy didn't recover, then central banks will have to print even more money and QE-infinity would take gold to $5,000.  Heads I win, tails you lose.  No-brainer!   Oops.

Where Should Interest Rates Be?
So then, let's see where interest rates would be on a normalized basis.  First, I thought that the range for the 'real' fed funds rate was around 2.00% - 2.50%.  But a quick googling tells me that it averaged 2.7% between 1984 and 2005 (real rates have been deeply negative in recent years, so no need to update).

If inflation is 2.0%, then the Fed Funds rate should be around 4.7%. What about the yield curve?   The spread between the 10-year treasury rate and Fed Funds rate since 1954 was 1% or so.  That would give us long term rates of around 5.7%.   In that case, this would imply a p/e ratio of 17.5x (as the high end).

However, the 20 year and 30 year average spread between the 10-year treasury rate and Fed Funds rate is 1.5% and 1.6% respectively.   Using 1.6%, we get a normalized 10 year rate of 6.3%, or an implied p/e ratio of 15.9x.

The S&P 500 index, on a trailing twelve month basis, is trading at a 19x p/e ratio now, and 16.7x forward earnings estimate.

Nominal GDP Growth Rate
OK, so the above normalized interest rate guesses might be a little "noisy".  I used real Fed Funds rate and then assumed a yield spread. That's too many indirect assumptions.  Don't assume because...
Another more simpler model for normalized long term interest rates is simply the nominal growth in GDP.

I just googled this and cut and paste it from an old BlackRock report.  The data is from 1963, so it shouldn't matter too much that it's not up to date.

Using this idea, I think the expectation for real GDP growth is between 2% and 3%, and inflation is expected to be around 2%.   The 10-year breakeven inflation rate (on TIPs) is currently around 2.1%.  It looks like it gets above 2.5% every now and then so we can use that too to be conservative.

So putting the above together, if you assume 3% real GDP growth and 2% inflation, that's a 5% 10-year treasury rate and implied 20x p/e ratio.

I think at the annual meeting, Charlie said that it would be insane to expect more than 1% growth over the long term.  If that is the case, and inflation is 2%, we'll be looking at bond yields of 3% (and 33x p/e ratio).

But more realistic might be 2.5% real GDP growth and 2% inflation for a bond yield of around 4.5% (22x p/e).  Oh, and that would be 5% and 20x p/e if you used 2.5% inflation.

You can use whatever assumptions you want and get your own 'normalized' long term interest rate.  And yes, I know.  Nobody can really forecast economic growth or inflation with any accuracy; I'm just thinking out loud and trying to get my arms around this stuff.

Low Inflation? Really?!
And yes, of course many of you would laugh at the notion of 2% or even 2.5% inflation.  With what all the central banks are doing around the world, it's not possible for inflation to remain low for long.  Even Buffett said that there will be consequences to all of this and it won't be pretty.  He may be wrong this time too, though; he was wrong in 1981 when he said:
In past reports we have explained how inflation has caused
our apparently satisfactory long-term corporate performance to be
illusory as a measure of true investment results for our owners.
We applaud the efforts of Federal Reserve Chairman Volcker and
note the currently more moderate increases in various price
indices. Nevertheless, our views regarding long-term
inflationary trends are as negative as ever. Like virginity, a
stable price level seems capable of maintenance, but not of
I have followed Japan over the years so I suspect we are in a similar situation (but much better, of course).  The old rules of monetary policy and inflation may not apply.  I know this sounds like "this time it's different".  But it sort of is in many ways when you think about it.

High Inflation in the 1970's and 1980's
Many people seem to think that we will have another 1970's-like inflationary situation.  It might happen, but what bothers me about that is that I strongly believe that the 1970's inflation wasn't really a function of bad policy in the 1960's and 1970's (well, the overspending in that period by the government was a catalyst for sure) but more of a huge adjustment of an unsustainable global monetary structure that was in place for decades.

I think the view is that the U.S. leaving the gold standard was one of the reasons why inflation went out of control, and our abandoning of the Bretton-Woods fixed currency system contributed to the chaos.  Books have been written that say things were fine with the gold standard and Bretton-Woods and only after we ditched them did things blow up (so therefore we should go back to them; which makes no sense given the history of price controls!).

Well, my view is exactly the opposite.  I just think the 1970's was a huge adjustment to the huge imbalances that were built up over the decades after World War II.  As we have seen over and over in the past twenty years with the Asian currency crisis, Latin American crises, Euro etc., fixed currency systems just don't work.  And neither did Bretton-Woods.  The 1970's was the global version of the above currency crises that we have seen over and over again since then.  And they were mostly due to fixing exchange rates, not floating them.  Fixing them allowed unsustainable imbalances to build up.

Gold prices were fixed for a long time too (even longer than the currencies in the Bretton-Woods system) so that had an even bigger imbalance built up.  It was quite a coiled spring by the time the price control was lifted.

So when I look at it that way, I don't see what that imbalance is, necessarily, that would cause high inflation now.  As Dimon said, a lot of the QE money is sitting as reserves in the banking system.  When QE is withdrawn, the money will leave bank reserves.  This has no real economic impact.

Where is the coiled spring today?  (Yes, QE is artificially keeping interest rates low.  That is one coiled spring to be sure.)

But anyway, despite all of that, I am not forecasting low inflation forever.  It's more of an expression of my doubts about high inflation on the horizon that so many people expect.  As I've said for a long time, my suspicion is that we go along the road that Japan has, but in a much better situation.

I really have no idea what is going to happen; where GDP or inflation will go etc.  I have no clue.

But playing with these various factors that might impact p/e ratios, I can see why many see the market as reasonably valued despite the really scary looking Shiller p/e charts etc.


  1. I would say that a discussion of how Buffett thinks about broad market valuation is incomplete without mentioning his article "How Inflation Swindles The Equity Investor". He basically describes exactly how he would estimate future market returns by looking at stocks as if they were priced like bonds. While the estimates he made in the article proved to be incorrect (ROE ended up averaging a much higher rate over the following three decades), it is still a very useful mental model for considering future equity returns and current valuations.

  2. First of all I love this blog.

    A few comments on the article.

    1) It's definitely true that stocks compete with bonds to some degree. Lower bonds yields have resulted in downward pressure on expected returns from stocks (higher prices). So it's perfectly reasonable to say that today's elevated valuations are "justified", as long as you accept that the prospective return of stocks will be far lower than the returns earned in the past from lower valuation levels. Today's valuations are "justified" just like the 1980s bear market low valuations were "justified" - those valuations turned in great returns over the next 30 years, these ones will result in very low returns. Today in the market you see a lot of people running your P/E analysis to say stocks are fairly priced...and then stating that they will match historical returns of 6-8% going analytical error in my opinion.

    2) Similarly, many people reference Japan's experience to conclude that low rates are here to stay and therefore you shouldn't worry about high US valuations....but they ignore the fact that the Japan experience included a 30 year equity bear market. Inflation was low in Japan because the economy went nowhere, stock EPS growth was terrible, and as a result multiples on Japanese stocks collapsed (as opposed to going to 50-100x as would be expected looking at the JGB yields).

    Buying stocks at these levels should allow you to do better than the <2% after-tax return on bonds over the long term (with wild vacillations in the short term), but you'll probably be looking at a 3% annualized return years from now, not 6-8% IMO (with better entry points available in the future).

    1. Furthermore, I've really enjoyed your posts on "outsider" companies.

      However, I wonder what the returns would be if the outsiders were starting in today's market with its P/Es over 20x (~30x for Russell 2000 stocks). How much did the low starting valuations of these companies juice returns (a driver that's less available today given general valuations are so much higher)? In fact, outsider companies today appear to have P/Es above the market's elevated levels (TDG) - can an outsider really earn outsider returns once that premium is priced into the stock?

      In addition, what if these outsiders had not been able to buy back loads of there own stock at P/Es under 10x (or in Buffett's case, many other stocks at ~10x)? One may argue that if their stock was overvalued they could use it as an acquisition currency, but Singleton was issuing stock at P/Es over 20x to buy companies with P/Es under 10x - a valuation discrepancy that appears to be long gone these days (the modern equivalent might be issuing stock at 20x to buy a company at 20x).

      What about all the outsiders that investors thought were outsiders but turned out to be ho-hum insiders?

      I love the concept, but just like gold in 2010, all good concepts pass a point of reasonableness at some price. If you can pinpoint a true outsider today, even with the premium their stock is likely to sell at, my guess is they'll outperform the market but the decades of 20% returns earned by the past crowd are likely a vestige of a bygone era if current valuation levels persist (which, thankfully, I think will not be the case).

    2. Good points. Prospective returns should certainly be lower now than before. Also, many would simply conclude that both stocks and bonds were cheap in 1981, and both are expensive now.

      Japan's bear market was because they started at a p/e of 80x or something back in 1989 and ROE's have been in single digits for he most part. The bear market was driven by p/e's going from 80x to 15x or something like that. We don't have that here (we had that in the NASDAQ in 1999, though). Plus Japanese businesses are run like a corporate welfare system (can't fire employees like you can in the U.S. (or as easily) or else they end up pissing off the Japanese govt, and that's usually not a good idea).

      And good point about Outsider companies. Returns would obviously be a lot lower starting from a higher p/e. But we'll see what happens with valuations. It's a different world for sure, but some will still do well. Remember how many thought Buffett overpaid for BNI and HNZ. They were 'fully' priced but BNI has done really well and HNZ op profits are up 50% or so (but we have yet to see what happens longer term).

    3. Oh yeah, and 3G's (Inbev) BUD purchase was 'fully' priced too but that turned out pretty good so far. I think good managers will find things to do and make it work. I don't think it's true that good deals can only be done when the whole market is cheap.

    4. Another aspect of the post that I think is interesting is just how much of an impact interest rates can have on stock prices. It's a lot easier to focus on financial statements/competitive positions than to do both that AND predict future interest rate changes. But as Buffett clearly states, a 10% 10Y yield in the future will have a huge negative impact on the intrinsic value of nearly all businesses.

      I think his response (in private) would be that yes, interest rates matter a lot, and he does think about them. I think he would say they won't go significantly lower, if they go a little lower or higher it won't matter, and if they go dramatically higher BRK is a cash machine (with a ton of excess cash currently) that can deploy at much lower prices.

      “I don’t think about the macro stuff. What you really want to do with investments, is think about what’s important and what’s knowable. Understanding Coke or Wrigley is knowable… but we have never bought a business or not bought a business because of any macro feeling of any kind… We don’t want to pass up the chance to do something intelligent because of some prediction about something that we’re no good at anyway.” – Warren Buffett, 1998 at the University of Florida

      How is that quote consistent with what you posted in the 1981 annual about how "macro stuff" has massive implications for business valuations? Basically, I think there is a difference between what he preaches in public and what he practices in private. In public he says, "don't worry about it." In private I believe he plans for a variety of outcomes but knows his limitations and doesn't let the uncertainty paralyze him.

      For today's environment, the possibility of lower prices in the future (as occurred in 2011 and 2009 despite the 3% bond yields investors draw such comfort from nowadays) should cause one to seriously consider setting some dry powder aside...but it shouldn't make you want to be 100% cash or refuse to look for bargains that could be much better than the overall market.

    5. Good points. The key difference between "macro stuff" and the 1981 letter is that he is merely evaluating stocks at the moment with the then existing interest rates. What Buffett avoids is trying to guess what will happen in the future; that's the key difference. For example, Buffett might think interest rates are too low and the market not cheap, but if he sees something he likes at a reasonable price, he will buy it. Others might say, we are in a bubble and rates will rise once QE ends and the market will go down with it, so I will wait until then to buy what I like. Buffett would NOT wait (if the price is right for the thing he is looking at).

      That's the main difference.

    6. Fair enough - I guess it all comes back to margin of safety. Buffett is fine buying 9% preferreds (that are presumable money good as 3G never loses) because even if rates go to 6% 9% still looks good (even though he may be sitting on a market-to-market loss). 30x peak earnings on the S&P doesn't have the same margin of safety ring to it. It's all a bit academic as the money is made at the individual security level and not trading SPY. Does feel like the pendulum is swinging into the greed zone.

    7. It is frustrating for those aspiring to be Buffett when most of his return was earned at much lower valuations. Can you still do well, yes, but it's a lot harder to get the big absolute returns when you start from a much higher valuation level. Where are the national indemnities today trading at 2x earnings?

  3. Great post. I've been discussing this idea for a couple years on my blog. I strong agree with almost all of your points.

    The one thing I disagree with is your view on why inflation got out of hand in the 70's. It's not due to Bretton Woods, but due to the baby boomers. During that period, you had population growth rates that were growing. I.e. population levels were non linear even on an exponential chart. What that meant is that aggregate demand was rising so quickly and for so long (because it was demographics driven) that aggregate supply had no chance of catching up. That was the main reason why inflation was so high for so long. Going off the gold standard, fiscal policies - they had an impact, sure. But the impact was much, much smaller than the demographic impact.

    The other thing I'll say is that I've spent a great deal of time studying really long term historical data, stretching back to the early 1800's. And my main takeaway is that while cyclical inflation concerns are always present, when measured in decades, the only real risks historically in a (mostly) free market system like ours were wars and demographic booms & busts. So I totally agree with you that no one knows what growth and inflation will be in the next year or two. But over the longer term - the time frame that matters for long duration assets like equities - there are methods with strong forecasting records. And they all suggest the current ranges are actually likely to continue to grind lower. Which of course has a positive effect on the present value of financial assets.

    I published a 3% target for 30y yields near the beginning of the year. I think ultimately we will see a 30x PE for the S&P on a reported, TTM basis.

    Cheers, and keep up the good work!

  4. Love the blog and the commenters that it draws. Keep up the good work. You are doing your readers a service.

  5. If economic growth ahead is slow such as 2.5% real that should also mean that corporate earnings in aggregate should slow (unless profit margins can expand even further). Wouldn't a slowdown in earnings growth cause P/E ratios to contract? Or do you expect low interest rates to potentially push P/E ratios higher even if earnings growth is well below the long term average?

    1. Hi, that's a really good point. But if nominal GDP does stabilize at 4-5%/year, let's say, and interest rates stay in that area, then even a non-growing company may be worth 20x p/e. If such a company (as in Buffett' example) paid out all it's earnings every year, that would yield the stockholder a pretax 5%/year even without growth. If such a company bought back shares, then per share earnings will grow 5%/year even without growth in total earnings.

      If interest rates stabilize a lot lower than 5%, then theoretically, stocks may be worth much more. As a poster said above, maybe stocks get to 30x p/e. But somewhere, I think stock investors would stop following bonds up (as it already has, actually). I think an equity return hurdle will bottom out way before interest rates...

      Or else Japanese stocks would be worth 100x p/e. I don't think Buffett would ever say stocks are fairly valued at 100x p/e even if long term rates went to 1% and stayed there for a few years...

      Anyway, the above post is only one way to look at things... and not really a complete, fool-proof answer on how to value the market.

  6. Hi,

    The Fed (and various politicians) seem determined to shrink the TBTF banks. Capital ratios and regulations seems to be the tool of the day. If you estimate that JPM for example would have to start and shrink considerably, how would you modify the valuation method? And is there anyone out there than can buy what they have to sell? Can they spinoff various parts? Can we please get a new post about this? :)

    1. Hi,

      Yes, this is all very interesting, but it's hard to talk about something we really don't know anything about yet. A lot of things are talked about but oftentimes, things change as people respond to the 'trial balloon'.

  7. Shiller P/E, of course, makes no sense. Equity looks for returns in future, not past. With current S&P 500 average ROE at 14.5 & PBV 2.77, we are looking at earning yield of 5.23, giving us TTM P/E of 19.1 - pretty close to the current real TTM P/E - indicating "reasonable" valuation. Returns going forward will depend on economy in future and we cannot predict that. With so much money, long term bond yield has lost its predictive power like it did in early 1980s, another extreme situation.

  8. KK---

    I liked the post. I am a bit torn here as I feel that the post is a touch too bullish for my taste.

    That said, a counterpoint needs to be addressed as well: the Fed Model suffers from money illusion and so to an extent, this post does as well. ( See any of the write-ups by Asness or Ilmanen for details. )

    I know you have a lot less data to work with, but comparing TIPS yields with equity yields (or a variant of Enterprise Value yields if you really wanted to do it right though no one seems to do this) is what would make the most sense here. And yes, I realize that comparing equity yields against negative or zero TIPs yields would indicate potentially even higher valuations for equities compared to what’s in your post. This could then segway into a discussion of duration risk for real interest rates, which is a potential hidden pitfall for equities, though naturally more for those ones whose valuations are almost entirely based on terminal values vs those businesses that derive significant value from near term cash flows.

    1. Hi,

      I know what you mean. As I was typing this post, Irving Fischer's 1929 quote kept going through my mind: "Stock prices have reached what looks like a permanently high plateau."

      The whole idea about normalizing interest rates the way I did was to show that even if long term rates go back up a lot and the FF rate goes back up to a normal range, the stock market's valuation would still be 'reasonable'. I think a lot of people are worried that the FF rate going back up or long term bond yields going back up is going to kill the stock market, but looking at it the way I did sort of shows that that doesn't have to be the case; there is quite a cushion still for rates to move up before making equity valuations look high.

      Anyway, one fun thing I like to do is to invert; would I be comfortable here with a massive short on stocks? How would I feel? If I was had a huge, leveraged short position on the market, what would I need to see? There are many things that can take the market down, of course, but from the above, it looks like I would really want to see inflation go up a lot. So a short on stocks (among other things) is a bet on inflation rising.

      Anyway, yes, this is all very complicated and nothing is so simple as a single blog post; it's just a thought, or one way to look at one thing.

      Thanks for thoughful comment.

  9. (It's kind of stunning to think that Buffett, in 1981, seemed to be saying stocks aren't worth 7x p/e but says they are reasonably valued now (or at least he said so relatively recently)).

    Buffett was correct saying that a 14% tax-free municipal was a better relative value than stocks at a 7x p/e. 14% tax-free outperformed the market over the subsequent 30-years. Regardless of what Buffett says about stocks relative valuation versus bonds to the public, that isn't how he has invested during the majority of his career. Here is a video of Buffett biographer Alice Schroeder ( She states that Buffett wants a 15% pre-tax return. That is Buffett's hurdle rate. He doesn't care about relative valuation. He wants a 15% pre-tax return. If anyone thinks they can get a 15% pre-tax return buying the S&P at today's valuation, I want what they are smoking. Buffett's recent comments about stocks have been carefully worded as a relative argument. Read them word by word. He is very deliberate when he makes public comments. In private, I have no doubt he would say that stocks are expensive in absolute terms.

    1. Hi,

      Good points. Buffett also said he likes to pay 9-10x pretax earnings for businesses and Munger said something similar recently at the DJCO meeting; that they like to buy things that yield 9% pretax.

      Buffett also does say that most people should be in an index fund. He said that in the most recent annual report too, that his wife's trust will be 90% S&P 500 index fund and 10% cash. And he wrote that with the market not too far from current levels.

      Also, keep in mind that he wants to earn 15% pretax return to buy something, but there is no way his current stock holdings are going to return 15% pretax over time from here (but he still continues to own them).

  10. I appreciate the reply. I was surprised by Buffett's recommendation to his wife's trustee. I would have guessed that he would instruct the trustee to buy Berkshire shares with the money. Regardless, Buffett's expectations from his recommended portfolio were not high, see below.

    “You also revealed something in the annual letter this year, where you said, you laid out the terms of your will, what you’ve set aside for your wife. Which, I didn’t know any of this,” Quick said.

    To which Buffett responded: “Well, I didn’t lay out my whole will. . . . I did explain, because I laid out what I thought the average person who is not an expert on stocks should do. And my widow will not be an expert on stocks. And I wanna be sure she gets a decent result. She isn’t gonna get a sensational result, you know? And since all my Berkshire shares are going to philanthropy, the question becomes what does she do with the cash that’s left to her? Part of it goes outright, part of it goes to a trustee. But I’ve told the trustee to put 90% of it in an S&P 500 index fund and 10% in short-term governments. And the reason for the 10% in short-term governments is that if there’s a terrible period in the market and she’s withdrawing 3% or 4% a year you take it out of that instead of selling stocks at the wrong time. She’ll do fine with that. And anybody will do fine with that. It’s low-cost, it’s in a bunch of wonderful businesses, and it takes care of itself.”

    I agree that his current stock holdings will not earn 15% pre-tax, but he didn't buy most of them at today's levels. He has also referred to many of them as permanent holdings.

    I agree with the poster above. One can't bid up stocks to much higher than average valuations with low interest rates as a justification and expect historical average returns from stocks. There is no free lunch. Bidding up stocks because interest rates are low will result in a relative return advantage over bonds, but a lower than average return from stocks based on history. One can't ignore the math.

    1. Totally agree... Returns will obviously be lower going forward from a higher price. There is no question about that.

    2. Charles DeVaulx at IVA, formerly at First Eagle, made a great point about low interest rates the other day in a conference call. He used Charlie Munger's old algebra adage, invert always invert. So instead of bidding up stocks because interest rates are low, let's invert. Why are interest rates so low? In a world of low/no economic growth, fair to expensive valuations, and generationally low interest rates, shouldn't I demand a higher margin of safety when buying equities instead of bidding them up because interest rates are low? Interest rates might be low because there are large imbalances in the world. Interest rates might be low because there is still a threat of deflation, which is not good for equities. Interest rates might be low because growth is slowing around the world. I think this is an interesting way to frame the dilemma.

    3. Good points. I don't disagree. You will notice, though, that the market didn't bid up equity valuations as interest rates went down. I would be really worried if the stock market did go up to 30-40x earnings for sure...

      It was interesting to hear that Buffett has 100% of pension assets (that he manages) in equities; no bonds, no cash. (If you look at the pension assets in the 10-k, that's not true, but that's because there are pensions that are not managed by Buffett himself).

    4. That was an interesting comment by Buffett. However, I will note that those pensions have positions in less than 10 stocks. That is a lot different than buying the S&P like he advised his wife's trustee to do.

      I'm not sure I follow about stocks not being bid up because of rates. Stocks have pretty much tracked QE. You will notice stocks ran up with QE 1 and then sold off after it ended. They ran up after QE 2 and sold off after it was targeted to end. Then QE 3 came out with no end date and stocks really took off. QE is ending soon. We will see how equities react to the final taper shortly.

      I'm not a macro investor. Macro is impossible and I learned the hard way. I just don't have a lot of good ideas right now and I don't see a lot of cheap stocks out there. There are always a few, but it's not easy to find a good idea right now. On the other hand, I see a lot of very expensive stocks and momentum stocks that need everything to go right to justify the current valuation. I'm not a short seller, but this is probably an idea rich environment for one.

    5. Yeah, as I reread my comment it was not clear about stocks not going up with rates. I meant to say that it hasn't gone up as much as rates has gone down. Using Buffett's method, stocks would still beat (or close to) bonds at 40x p/e because the earnings yield of 2.5% would be similar to bond yields. But of course, I doubt Buffett would ever call 40x p/e fair, but who knows...

  11. Have you given any thought to Buffetts favorite valution metric Maket Cap/GNP? We have surrpased 2008 levels and approaching 2000 bubble levels. Does this give you pause for conern? Thanks.

    1. Hi,

      That's an interesting question. Since I tend to look at things stock for stock, it doesn't worry me much. For example, if I like BAC or JPM due to their valuation, what difference does the market cap/GDP ratio make? Not much. OK, so sometimes it might be indicative of irrational exuberance and that might be bad news for the market and economy in general.

      So I do tend to look and read about those things. But the market cap/GDP in particular is not that interesting to me because of all the globalization going on. At one time, BUD was a primarily U.S. domestic beer business. Now it's an internatinal mega-brewer. Goldman Sachs was a primarily domestic/U.S. investment bank, but now gets more revenues outside the U.S. (or close).

      Google is a mega-cap that gets a lot of revenues outside the U.S. too.

      Every time there is a cross border merger, the U.S. stock market capitalization (versus domestic GDP) expands.

      I also understand that other metrics (like profit margins) are at historical highs and seemingly unsustainable. Maybe they are too high and unsustainable. I don't know.

      But what I do know is that the approach to investing that I subscribe to doesn't try to guess what is going to happen to the market according to these measures.

      In any case, I am sort of always concerned with the market, lol... When it's high, I worry we will crash, and when it's cheap like in early 2009, I worry that we will plunge into a depression and cheap stocks are not cheap enough...

    2. kk, recall the ratio is market cap/GNP, NOT GDP.

      GDP includes everything that is generated within the physical United States.

      GNP includes everything that is generated by Americans period - this includes foreign sources of income.

      So your point about GS or Google having international revenue does not apply to GNP because that would, in fact, be part of GNP. So, the market cap/GNP ratio, I think, is very well applicable today.

      In fact, if you look, you'll see that US GNP is higher than GDP.

    3. Hi,

      That may be so. I thought it was GDP and I see references to Buffett indicator being against GDP but I haven't looked at the original article so I'm not sure.

      But either way, it wouldn't make much difference. You are correct in what you say about what GNP includes but GDP doesn't. If you look at the two, though, they are very close. I was wondering why, but then realized that it is because GNP has a deduction of production within the U.S. owned by foreignors.

      The stock market has no such deductive component so the stock market to GNP ratio would still have a similar distortion to one compared to the GDP.

      Thanks for dropping by!

  12. KK -- it's been a while since I studied Macro Econ, but I think the question was on GNP and if my memory serves right, whereas GDP looks at the total amount of 'stuff' that is produced in the US, GNP looks at stuff made by US persons, irrespective of location of that production.

    Whether BUD as an inverted corp still counts as a US person, I don't really know. But I think GNP tries to deal with a lot of the shortcomings you mentioned regarding GDP. (For example in looking at the total scope of companies like Goldman and Google.)

    1. Hi,

      Good question. I think domestic production by foreigners is deducted so it still isn't apples to apples.

  13. Hello Brooklyn Investor: Did you ever look into CBI. It would be great to read your investment thesis on that company.

    1. Hi,

      Yes, I did go back and read some annual reports etc... and it looks like a really well run company with a nice shareholder base (including BRK), but haven't gotten to the point of making a post about it.

    2. I'd be interested to hear your thoughts. In addition to BRK, Greenblatt has it as one of his top holdings in Gotham Enhanced Return. Also the company is selling at a price that is less than what both of them started building positions at. I think it has the potential to be a very good cloning opportunity.

    3. I think you are right. They are guiding 4.80-5.65 in adjusted EPS for full year 2014 and it's trading at under $55, so that's a 9.7x - 11.5x p/e; that's pretty cheap if they keep growing.

  14. Hey, great blog, I like it. I think inflation is always there und will be more in the future. When the interests rates starts to grow, everythink will be moving. And then the stock markt goes down and the first losers are companies like Facebook or Tesla, where the P/E is over 50.

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  15. Hi KK,

    Buffett made some comments about his use of the market cap to GDP ratio at the Fortune MPW conference. It is on youtube if you're interested. Nothing earth shattering or anything but I thought it was interesting that he seems to indicate that the ratio is not particularly special, just was one that did a good job of demonstrating the froth at the time.

  16. At the time of the Sun Valley conference near the top of the internet bubble, that is.

  17. Hi,

    I want to make a short remark for this article.
    You are comparing Japan and the US for interest rates going forward which I found unwise. Why? Because when Japan has first hit low rate era in 90's, they have the back up of public savings. The people savings were and still are in the government bonds. While for the US, it is not so. Hence my disagreement.

    1. Thanks for the comment. That's a very good point and many people said the same thing a while back. But interest rates have already been far lower for far longer than anyone ever imagined back in 2008/2009.

  18. If only I had Buffett's deep knowledge in fundamental analysis... Of course, technical analysis plays a pivotal role in trading but fundamental analysis gives another aspect of an investment.

  19. Perhaps it is not so much about market valuation but rather the valuation of the stock price. I usually will focus on PEG as a guideline.


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