Understanding Stock Market Returns – Part 2

On July 19, 2010, I posted part 1 of this article in which I argued that long-term stock market performance is largely explained by corporate profits. Students of stock market history will immediately recognize that this explanation of stock market returns fails to explain the large variability in stock market returns over multi-decade periods during the past century.

As Buffett pointed out in a 1999 Fortune article, in the 17-year period from December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average (DOW) was flat, going from 874.12 to 875.00. In stark contrast, during the ensuing 17-year period, the market advanced from 875.00 to 9181.43, which comes out to a whopping annual return of 19%. Surprisingly, GDP rose 373% during the first period compared with 177% during the second period.

Buffett explains that interest rates on long-term government bonds were a major factor that held the stock market back in the first period because they went from 4.20% at the end of 1964 to 13.65% at the end of 1981. Just the opposite happened in the second period: interest rates on long-term government bonds went from 13.65% to 5.09% at the end of 1998. Because all assets must compete with the risk-free return available from long-term government bonds, as rates move higher it causes a reduction in the value of all competing assets. When rates fall, all competing assets are re-priced at a proportionately higher level. This is easy to see in the prices of bonds because they have a fixed coupon and, if held to maturity, return the invested principal. The impact on bond price when interest rates change can be dramatic.

Whereas this relationship between asset value and interest rates is easy to see in bond prices, it can be harder to immediately see in the price of equities, because a number of other factors affect the price of stocks which can obscure this relationship, especially in the short run. Buffett argues that regardless of these other factors the effect of interest rates on the value of equities is real and constant, much like the effect of gravity, and over time will cause equities to be re-priced.

Another factor in the extraordinary returns from 1981 to 1998 was the fact that corporate profits as a percentage of GDP rose significantly during that period. Buffett points out that starting from a depressed level of 3.5% of GDP, after-tax corporate profits rose steadily, ending the period at around 6%. The 6% level represents the upper end of their normal long-term range. This increase in corporate profits relative to GDP provided a powerful boost to stocks.

Finally, Buffett points out that the final significant factor affecting stock prices is sentiment. Investor sentiment over time oscillates between periods of extreme pessimism and extreme optimism. A large part of Buffett’s success is having the emotional discipline and fortitude to purchase stocks during these periods of pessimism, which can make even great businesses available for less than they are worth.

At the beginning of the 1980’s, Buffett points out that investors were very pessimistic about the outlook for corporate profits, especially given the historically high interest rates that prevailed at that time. As the market advanced over this 17-year period, investors became increasingly optimistic owing to the extraordinary returns the market was throwing off. By the mid-90’s, the party was in full swing and many know-nothing investors began to get involved simply because stocks were going up. These investors did not want to miss the easy profits that were sure to follow. The rise of the Internet sent the whole thing into further orbit as it provided a justification that this time things were different and that equity prices could decouple from the constraints of traditional valuation metrics owing to the paradigm-shifting wealth and productivity that the Internet would usher in.

To sum up, we can identify three primary variables that account for stock market performance:
1. Corporate profits
2. Interest rates
3. Investor sentiment

If you understand these key variables, you will be in a better position to value – not predict – the level of the general stock market. Buffett does not primarily take his cue from the general market but from the availability of undervalued securities. He is primarily a bottom-up investor who puts much less weight on macro-economic factors than he does on seeking out undervalued companies within his circle of competence where he can arrive at a usefully certain conclusion about what they are worth.

Buffett believes that macroeconomic forecasts are difficult to make and that the level of certainty which he can reach about the long-term prospects of select companies within his circle of competence is much greater. To him, it would make no sense to give up the advantage afforded by this certainty by making it secondary to his ability to forecast the economy.

Nevertheless, Buffett has a very deep understanding of the general stock market and uses that knowledge to assess the valuation level of the general market. This is grounded in the reality that virtually all stocks, unless there is a clear extraneous factor such as a pending acquisition, decline in a sharp correction or bear market. Therefore, it makes sense to be increasingly cautious if the market reaches price levels that are not supported by its fundamentals.


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