Buffett Is Bullish.
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 (Fig. 1). 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 (Fig. 2). 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.
I asked Joe to go back 100 years and play with the numbers. Here is what he came back with:
(1) We have a monthly series for the DJIA starting December 1917. We can put it on a ratio scale and compare it to alternative compounded annual growth rate (CAGR) lines (Fig. 3). 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 between the 5%-6% CAGR trends.
(2) Starting from the last trading day of 2016, when the DJIA was at 19,763, Joe calculates 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%) (Fig. 4).
(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% (Fig. 5). 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 (Fig. 6). Joe and I derived that yield by subtracting the CPI inflation rate from the S&P 500’s earnings-price ratio.
(5) We also have a total return index for the S&P 500 that includes reinvested dividends (Fig. 7). Since the mid-1950s, it has tended to rise around the 9%-11% CAGR lines. Adjusted for the CPI, it has been rising around the 6%-8% lines.
Strategy II: Fundamentals & Technicals Are Bullish. Notwithstanding Buffett’s happy talk, we now have to consider the front-cover curse. Buffett’s genial visage graces the cover of the Forbes’ centennial issue. Contrarians need to be on high alert. On the other hand, while most measures of stock valuation seem dangerously high, including Buffett’s ratio, Barron’s this week includes an article, “Bears, Return to Your Caves—at Least for Now,” by Vito Racanelli. He concludes with an observation that has been our mantra for quite a while during the current bull market: “Bear markets are generally caused by recessions.” He rightly notes that “the evidence for that anytime soon is weak.” Thankfully, Vito’s story wasn’t placed on the front cover.
The bullish article starts as follows: “This old bull market, the second longest in history, continues to be mocked, doubted, and just plain vilified. Okay, the last is an exaggeration, but investor euphoria is absent, even as stocks hit new highs after new highs in September. Instead, investor sentiment is neutral at best, not the kind of thing that dispatches an aging bull.” Vito reports that Goldman Sachs’ Chief US Equity Strategist David Kostin wrote in a recent report that institutional investors are “tormented bulls.” Joe and I have been calling them “fully invested bears” (“fibers”) for a long time.
Barring an exchange of intercontinental nuclear missiles with North Korea, an ETF flash crash, or some other black swan event, the outlook looks good for the rest of the year, according to the upbeat article: “Since 1928, there have been 29 Septembers in which the S&P 500 made a 12-month high. Following those 29 instances, the market rose over 80% of the time in the fourth quarter, averaging a 3.7% increase, says Doug Ramsey, chief investment officer of the Leuthold Group. Better still, 15 of those 29 September price highs were also accompanied by 12-month advance/decline line highs—as is the case now. Stocks increased an average 5.9% in the fourth quarter in those 15 instances.”
Consider the following supportive developments:
(1) Tax reform. It’s too soon to tell how bullish Trump’s tax reform plan will be for corporate earnings. The latest outline was released last week. It proposes to slash the statutory corporate tax rate from 35.0% to 20.0%. The effective tax rate was 26.4% for the S&P 500 companies last year (Fig. 8). It was 21.3% for all US corporations during Q2-2017 (Fig. 9).
Stock prices started to discount a bullish round of Trump tax reforms the day after Trump was elected (Fig. 10). From November 8 through the end of last year, forward P/Es soared as follows: 16.4 to 16.9 for the S&P 500, 17.2 to 18.7 for the S&P 400, 17.4 to 19.8 for the S&P 600. Investors obviously believe that smaller companies have more to gain from a tax cut than larger ones, which generally have plenty of resources to game the current system. The SMidCaps spent most of this year giving back some of these valuation gains as tax reform seemed like a more distant and less likely outcome.
However, these valuation multiples have started to perk up now that tax reform is actually on the table after release of the administration’s nine-page proposal, “Tax Reform: Unified Framework for Fixing Our Broken Tax Code,” dated September 27, 2017. Once again, investors are particularly upbeat about the impact of tax reform on smaller companies. The forward P/E of the S&P 600, which jumped from 17.4 on November 8 to a high of 20.5 on December 6, sank back to 18.3 on August 21. On Friday, it jumped back to 20.1.
The Trump proposal remains very sketchy on the lower tax rate that might be applied to repatriated earnings. However, short of a major geopolitical blowup, its hard to see the stock market going down much with the possibility of over $2.5 trillion coming back home.
(2) Forward revenues and earnings. While forward P/Es have been meandering lower since early this year until they rebounded last week, forward revenues and earnings have continued on to record highs for the S&P 500/400/600 (Fig. 11 and Fig. 12). Earnings estimates for both 2017 and 2018 for all three have been remarkably firm all year (Fig. 13). Earnings growth rates for this year and next year are currently as follows: 11.1% and 10.9% for the S&P 500, 11.0% and 13.7% for the S&P 400, and 5.7% and 20.3% for the S&P 600.
(3) Breadth. The percentage of the S&P 500 companies trading above their 200-day moving averages rose to 70.7% on Friday, up from a recent low of 59.6% on August 18 (Fig. 14). The percentage with gains on a y/y basis was 74.7% on Friday, a solid reading for sure (Fig. 15).
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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