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Want To Know What Your Returns Will Look Like In 17 Years? Buffett Has Some Insights

on Sat Nov 26, 2016 9:39 am

  • We’ll discuss the primary reasons behind long term returns on investments.
  • With interest rates being close to zero, we have to exclude lower interest rates benefiting future returns.
  • General market conditions create a negative asymmetric risk reward situation, but there is a better option.

With the Dow passing 19,000 and the S&P 500 passing 2,200 points, it’s time to take a look at the markets, investors’ expectations, and the real possibilities that those expectations will be met.

Today we’re going to employ Buffett’s perspective on the general stock market to assess future returns by going through a rare article where he discusses general market valuation, something he is usually unwilling to discuss as his focus is on individual company valuations. Therefore, to get his perspective on general markets, we have to go back to 1999 when the Dow was at 12,000 points and he elaborated on the relation between value and market levels.

This analysis is essential to anyone who sees themselves as a long-term investor as it explains the main factors behind long-term returns on investments.Buffett begins his article by defining investing, and it’s always good to remind ourselves of what investing really is.

“Investing is laying out money now to get more money back in the future–more money in real terms, after taking inflation into account.”

He discusses two very interesting periods for stocks: the 17 years from 1964 through 1981, and the period from 1981 through 1999. We’ll add a perspective on the period from 1999 through 2016, which is exactly 17 years, and give an indication of what we can expect in the next 17 years based on his input.

Inflation-adjusted Dow Jones index since 1964

From 1964 through 1981, the Dow went nowhere in nominal terms—Dec. 31, 1964: 874.12 Dec. 31, 1981: 875.00—but lost 66.8% in real terms. Investors often forget to take into account inflation, but Buffett’s definition clearly states that inflation has to be taken into account.

However, during that period, the U.S. economy rose 370% while the sales of the FORTUNE 500 more than sextupled. Buffett explains what happened by using two metrics: interest rates and corporate earnings to GDP.

“Interest rates act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull.” – Warren Buffett

Interest rates on long term government bonds went from 4% in 1964 to more than 15% in 1981. This increase in interest rates is almost perfectly correlated with the real term decline in the Dow. Interest rates went up 3.75 times while the Dow fell 67%. An asset that falls 67% in value has to increase 3 times in order to return to its previous value.

According to Buffett, investors at that time were extrapolating future trends based on past inputs, something like driving a car and looking in the rear-view mirror instead of through the windshield. By expecting higher interest rates and lower profits, investors valued the Dow equally to its level from 1964.Interest rates have been falling since 1981. 10-year treasury yields went from above 15% in 1981, to around 5% in 1999.

10-year treasury yield

s the risk-free rate given by the government decreases, assets become more attractive. This led to a stock boom that ended only 17 years later with the crash.Buffett’s article was written just before the crash forecasting that stocks should grow at the same level as GDP if interest rates remain the same.

Fortunately for investors, in the last 17 years interest rates have declined further. From 5% to the current 2.26%.This 50% decline in interest rates should have transformed into a 100% appreciation in stock values. But it didn’t do that due to the high valuations back in 1999.

The Dow grew 58% in nominal terms and 15% in real terms as through the 17 years inflation ate up a pretty big part of the cake. In the meantime, real GDP grew 35%, but what has grown much faster since the 2001 recession were corporate profits in relation to GDP. From an average range of 3% to 6% of GDP, corporate profits grew to 9% of GDP in 2006.

The last available data shows that corporate profits are at 10% of GDP. According to Buffett, this situation is unsustainable for the long term as competition and political issues should return this level to a healthier range between 3% and 6%.It must be stated that much has changed since the 2000s. Low interest rates enable high levels of leverage which increase corporate profits.

U.S. corporate profits and real GDP

We’ll conclude that the nominal returns investors enjoyed in the last 17 years came firstly from lower interest rates and only then GDP growth.One thing is certain, interest rates can’t go much lower and have a positive impact on asset values. By taking such a beneficial variable off the table, we’re left only with the risk of higher interest rates and the hope of stable interest rates.

Unfortunately for stock owners, It is very probable that interest rates will increase in the next 17 years, starting from the much discussed FED meeting in December. Further increases in interest rates will depend on how the economy is doing, employment, and inflation. If interest rates go up, asset values will go down.

It’s very simple, it doesn’t have to happen immediately as future expected growth or bubbles can keep asset prices higher, but eventually it will happen as investor understand the risk and reward puzzle.Corporate earnings will grow alongside GDP growth. Thus above 2% per year, but not much more than that.

U.S. GDP growth forecast – World Bank

As Buffett avoids discussing market valuations, we haven’t mentioned them up until now. But with the S&P 500 earnings yield at 3.95% and earnings expected to grow at around 2%, you shouldn’t expect higher return rates in the next 17 years from the aggregate stock market.

S&P 500 earnings yield

No matter what the majority of investors say, passive funds or rear-view mirror expectations, U.S. stocks in general are not going to give you much higher returns than 4% or 5% in the next decade at these valuations.

Long term investing is pretty straightforward. Your returns are correlated to the underlying earnings of the assets you own with potential boom periods due to euphoria and lower interest rates, and potential bust periods due to panic and higher interest rates.

A potentially positive variable is excluded from the equation as we know that interest rates can’t go much lower. So, positive asset booms due to lower interest rates, or what we have been enjoying in the last 34 years, are excluded.

Another positive variable that is excluded is earnings growth. Slow GDP growth will disable significant earnings growth. If interest rates and competition increase, they will even hit earnings and we could see them fall to the historical average below 6% of GDP.

There could be more short to midterm positive catalysts in front of us that will push the stock market higher in the next few years, but from a longer-term perspective, the situation indicates high risks and low rewards. Further increases in interest rates, to lets say 4%, could easily lower the S&P 500 by 33% as the required returns rate jumps from the current 4% to 6%.

The option in front of long term investors is to sell general stock market assets like index funds, and to buy stocks that offer better earnings yields, better growth prospects, and lower interest rates and other risks.

Sign up using the link in the Editor’s Note below to put your name on the list to receive updates on my soon-to-be released new newsletter, Global Growth Stocks, where subscribers will receive monthly stock picks that have much better risk reward tradeoffs than the general stock market.

source: investiv
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