Created 2/21/09
A recent story in Fortune Magazine1 titled “Buffett’s Market Metric Says Buy” discusses how the Total Market Value of U.S. Stocks as a Percent of GNP can be used as a metric to gauge whether stocks are appropriately valued. The story attributes this metric as one that Warren Buffett uses, and quotes him from a previous story2 as saying, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you.” The story shows a chart dating back to 1924, showing a caption that reads “For most of the 20th century, stock values ranged from 40% to 80% of GNP.”
The story indicates that as of January 23, 2009, the ratio was estimated to be 75%; and Warren Buffett has apparently been buying stocks according to his October 17, 2008 New York Times op-ed.
In this period of economic upheaval, with many markets and indicators experiencing never-seen-before conditions, how relevant is a metric such as the Total Market Value of U.S. Stocks as a Percent of GNP? This question is particularly important, as making proper asset allocation decisions are perhaps as tricky now as they have ever been, if not more so.
There are many questions to ask now if one is adopting a “buy and hold” philosophy with regard to stock purchases. Aside from the basic questions, such as the desired duration of the investment time horizon, there are more problematical issues such as the visibility of forward earnings and the multiples that will be applied to these earnings. Although the general stock market indices have fallen significantly versus the October 2007 highs, it is not difficult to envision additional significant declines given a variety of factors. For example, if one were to assume S&P500 earnings of $50, and an earnings multiple of 10, the resulting price level of 500 would be significantly below the recent price of 788.
Given that the Total Market Value of U.S. Stocks as a Percent of GNP is now within the 70%-80% range, is now be a good time to buy stocks? Although there are a multitude of issues that have to be examined, four issues appear paramount: the ability of the economy to revive; the likelihood of inflation; the relevance of the “buy and hold” philosophy; and the possibility of mean reversion of the Total Market Value of U.S. Stocks as a Percent of GNP.
The ability of the economy to revive
The first issue has to do with one’s belief in the ability of the economy to revive. Will the various stimulus and intervention measures that have, and will be, enacted in order to “improve” the economy work? And if so, how long will it take for them to “kick in?” What would be the characteristics of such an economic revival? The Total Stock Market Value is largely dependent upon confidence in earnings and the multiple afforded them. As seen in the Total Market Value of U.S. Stocks as a Percent of GNP, this confidence, as measured against GNP, appears to have taken a rather precipitous dive lately, apparently the largest and fastest since 1924.
The likelihood of inflation
The second issue is the likelihood of inflation, and the effects it would have on stock market valuations. As Buffett indicated in the NY Times OpEd piece, he believes “the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary.” If one believes an inflationary - as opposed to a deflationary - environment is forthcoming, it may bolster one’s confidence in stocks. But is the inflationary bias assumption a sound one? And if it is, will stocks indeed do well in such an inflationary environment? It might well depend upon the degree of inflation, or reflation, that takes hold. There is little past history of how U.S. stocks fare in an inflationary environment, so it is difficult to look to the past for answers. Yet another issue might be, if there is inflation, how will investors view, and price, this inflation? If it seems “containable” or “controllable” it may well be viewed more positively than if it appears uncontainable. Of course, the attractiveness of stock market returns in such an inflationary environment would have to be viewed on a “real” basis, which might considerably alter their relative attractiveness.
Another issue with regard to stock market returns in an inflationary environment may be the forward earnings multiple attached to such earnings. The earnings multiple may well stay depressed if the market believes that earnings are being “pumped up” via inflation. This issue is problematical on many fronts. By definition, either the inflation would have to come to an end soon (which would likely negate any benefit the inflation would have on earnings) or, if the inflation was allowed to fester, it may turn uncontrollable, in which case it is doubtful that a high PE ratio would be afforded.
There are various other issues with inflation. For instance, it is commonly assumed that in such an inflationary environment, stocks would rise as both earnings and revenues would be inflated. This assumption deserves scrutiny on many levels. One such question may be how well company managements may be able to adapt to managing in such an inflationary environment? It would undoubtedly bring its own challenges, and depending upon the rate and severity of such an inflationary condition, corporations could find such changes to be very vexing. As seen in the severe economic decline that accelerated in 2008, corporations as a whole can experience severe difficulties when economic conditions change in a rapid and unpredictable fashion.
The relevance of the “buy and hold” philosophy
Much of the “buy-and-hold” philosophy is predicated on the past history of the stock market. “Buy-and-hold” over long periods of time have generally paid off well, if not very well, for both investing in broad indices as well as many individual stocks. Many investors, including Warren Buffett, have done very well by buying well-run / “blue-chip” companies and holding them for long periods of time. This strategy assumes, among other things, that the economy will keep growing over time (albeit with inevitable temporary declines), and that one is able to identify well-run companies that will outperform companies at-large, both on a revenue / profitability basis as well as on a stock-market basis.
One aspect of this “buy-and-hold” philosophy that has been put to the test over the last couple of years is whether one can identify well-run companies that will continue to be successful in the future. In the past couple of years, there have been many companies that have had stellar reputations previous to the economic crisis that now are either struggling or owe their continued existence to direct government intervention measures. This illustrates that successfully navigating through rapidly changing economic adversity is very difficult even for companies that might appear to be well-managed.
Furthermore, the uncertainty and stresses caused by the economic crisis appear to have caused many managerial mistakes that could prove very costly over time.
Adding to the uncertainty of corporate viability is if/when the credit markets will become less restrictive. This is especially problematical at a time when stock market weakness makes attractive stock market financing difficult.
The possibility of mean reversion
Another issue arises when one takes a long-term view of the Total Market Value of U.S. Stocks as a Percent of GNP, and that is the concept of mean reversion. As seen on the chart, the March 2000 peak of 190% was well above any other peak – in fact, it appears to be at least double that of any other peak since 1924. Given that spike, one may expect some type of mean reversion to occur. If it were to occur, the resultant fall in the ratio may be to what would currently seem like shockingly low levels, with concomitant stock market valuations.
If one doesn’t believe that mean reversion will occur, one seems to be implicitly believing in conditions that would support belief in the steadfastness of a long-term upward revision in the ratio. If this were the case, what might be the fundamental drivers of such an upward revision? Are such drivers sustainable?
Conclusion
Along these lines, if the ratio ranged from 40% to 80% for most of the 20th Century, as claimed by the article, why would Warren Buffett think that 70-80% (the high end of the long-term range) represents a buying area? Is this driven by an inherent belief that there now exists conditions that warrant a long-term upward revaluation in the ratio?
For the aforementioned reasons, as well as many others, the risk of continued disappointing stock market returns seems high. There seems to be considerably more risk than that indicated by the Total Market Value of U.S. Stocks as a Percent of GNP ratio.
Even if one adopts a “buy and hold” philosophy, there is no rule saying one has to be constantly invested. History has shown that with any investment, the timing of the investment purchase is paramount; and in today’s environment this timing factor seems more important than ever.
1 “Buffett's metric says it's time to buy” Fortune Magazine, February 16, 2009 http://tinyurl.com/dc6ulz
2 “Warren Buffett On The Stock Market” Fortune Magazine, December 10, 2001 http://tinyurl.com/e7nwj
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