Mr Buffett on the Stock Market, 1999
Buffett discusses his concerns over market valuations, speculative frenzy, how rates impact equity valuations, his process, and the mistakes of past investors
In September 1999, Warren Buffett would do something that he is not known for. Through a series of talks with close friends and business partners, he would express his concern about the overall level of the market. He did this both analytically and by making subtle references to the past. Just six months later, the Nasdaq, the index fueled with aggressive speculative fever, would reach an all-time high before embarking on an equally aggressive reversal that would take over two and a half years to find a bottom.
Fortune magazine’s Carol Loomis was fortunate enough to have access to a couple of those intimate talks and recounted Buffett’s sentiments from the time. While making sure his apprehensions was not a predictive exercise, Buffett cleverly addresses the 1999 period through various means. On one occasion he details how interest rates affect cyclicality and equity valuations. Following the Volcker era (1979 to 1987) of 20% rates, the world had more recently endured rate changes throughout the Gulf War (1990 to 1992), the soft landing of 1994/95, followed by the Bond Massacre (1995 to 1997), the global currency crisis (1998) and, at the time the article was written, was in a loosening cycle. From June 1999 through February 2000 (the month before the tech bubble popped), the Federal Reserve had hiked rates 75bps to 5.75% and would hike by a further 75bps through May 16th, 2000.
He later explains that while Berkshire focussed “almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market” that “sooner or later - value counts”. This foreshadowing implied that the frothy state of the overall market was becoming hard to ignore. Though he does address the level of the market, he makes it clear that he “will not be predicting its next moves”. Instead, he ominously describes the later stages of speculative frenzy; commenting on the social flywheel of peers watching peers get “rich” in the stock market, and likening later entrants to the bull market to Pavlov’s dog; conditioned to smell money at the sound of the opening bell. The conversation then migrates to Buffett's warning that revolutionary industries (such as aviation and automobiles) don’t always enrich the masses despite having a profound impact on society and infrastructure. In this instance, while not addressing the point directly, he is talking about the internet stocks that would plaster the front pages of the Journal on the way up and, soon, on the way down.
The talks stand as a great, eerily ominous, pre-crash autopsy that highlights the importance of being able to think for yourself. No doubt Buffett’s words would have mostly1 fallen on deaf ears at this stage in the market but he expressed what was concerning him. The lessons on speculative frenzy and the influence of rates are ones that can be carried forward too. In typical Buffett fashion, the text is also littered with sage advice, insights into Buffett’s process, and the occasional joke. I hope you enjoy it.
Choice Quotes From the Article
Overall market causes concern: At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.
Why the DOW was flat for 17 years & rates: To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.
His love for 1929: I'm quite fond of 1929, since that's when it all began for me. My dad was a stock salesman at the time, and after the Crash came, in the fall, he was afraid to call anyone - all those people who'd been burned. So he just stayed home in the afternoons. And there wasn't television then. So I was conceived on or about Nov. 30, 1929 (and born nine months later, on Aug. 30, 1930), and I've forever had a kind of warm feeling about the Crash.
Recency bias: And as is so typical, investors projected out into the future what they were seeing. That's their unshakable habit: looking into the rear-view mirror instead of through the windshield.
Late-stage bull market fever: Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. Like Pavlov's dog, these "investors" learn that when the bell rings - in this case, the one that opens the New York Stock Exchange at 9:30 a.m. - they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich.
Invert, always invert: So here is an industry that had an enormous impact on America - and also an enormous impact, though not the anticipated one, on investors. Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then - it's better sometimes to turn these things upside down - and that was to short horses.
Focussing on what matters: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Mr Buffett on the Stock Market
The most celebrated of investors says stocks can’t possibly meet the public’s expectations. As for the internet? He notes how few people got rich from two other transforming industries, author and aviation.
Fortune Magazine, 1999
Warren Buffett, chairman of Berkshire Hathaway, almost never talks publicly about the general level of stock prices - neither in his famed annual report nor at Berkshire's thronged annual meetings nor in the rare speeches he gives. But in the past few months, on four occasions, Buffett did step up to that subject, laying out his opinions, in ways both analytical and creative, about the long-term future for stocks. FORTUNE's Carol Loomis heard the last of those talks, given in September to a group of Buffett's friends (of whom she is one), and also watched a videotape of the first speech, given in July at Allen & Co.'s Sun Valley, Idaho, bash for business leaders. From those extemporaneous talks (the first made with the Dow Jones industrial average at 11,194), Loomis distilled the following account of what Buffett said. Buffett reviewed it and weighed in with some clarifications.
Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss. But I want to make one thing clear going in: Though I will be talking about the level of the market, I will not be predicting its next moves. At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it's going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.
Conor: Buffett seldom makes broad prognoses of the overall market. One of the more notably occurances was in 1969. That year the stock market was booming and even junk stocks were selling at premium prices. Buffett couldn’t find bargains anywhere and so he sent a letter to his partners:
“I am out of step with present conditions. When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble and so on. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently, easy, profits to embrace an approach which I don’t fully understand, have not practised successfully, and which possibly could lead to substantial permanent loss of capital”.
After 13 years, he decided to fold up the partnership which gained thirtyfold in its value per share, and through the addition of more than 90 members and the success of its investments had grown to over $100 million.
So what I am going to be saying - assuming it's correct - will have implications for the long-term results to be realized by American stockholders. Let's start by defining "investing." The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future - more money in real terms, after taking inflation into account. Now, to get some historical perspective, let's look back at the 34 years before this one - and here we are going to see an almost Biblical kind of symmetry, in the sense of lean years and fat years - to observe what happened in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981. Here's what took place in that interval:
DOW JONES INDUSTRIAL AVERAGE
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00
Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move. And here's a major and very opposite fact: During that same 17 years, the GDP of the US - that is, the business being done in this country - almost quintupled, rising by 370%. Or, if we look at another measure, the sales of the FORTUNE 500 (a changing mix of companies, of course) more than sextupled. And yet the Dow went exactly nowhere.
Conor: For context, here is a chart of the Dow Jones Industrial Average (DJIA) over that time frame. From December 1964, the DJIA would fall 10% from its prior high in 1966, before collapsing 45% between 1968 and 1970. After retracing those lows in 1972, the indice would fall 68% by 1974. Only to fall another 35% from the highs in 1978.
Although Buffett is correct in saying that between 1964 and 1981 the DJIA went “exactly nowhere”, it’s not as though this period was boring. That said, the fact that it ultimatley went nowhere in 17 years, and with a boatload of ups and downs to boot, is exactly the point Buffett is making.
If you were to adjust this time period for inflation, it becomes evident that investors in the DJIA lost out on more ways than one.
To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.
Consequently, every time the risk-free rate moves by one basis point - by 0.01% -the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect - like the invisible pull of gravity - is constantly there. In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there - in that tripling of the gravitational pull of interest rates - lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere. Then, in the early 1980s, the situation reversed itself. You will remember Paul Volcker coming in as chairman of the Fed and remember also how unpopular he was. But the heroic things he did - his taking a two-by-four to the economy and breaking the back of inflation - caused the interest rate trend to reverse, with some rather spectacular results.
Conor: I covered this period in “A Hike Across History”. This was an era where the United States battled with lingering inflation. Buffett’s “two-by-four” analogy is correct, but I prefer to think of as taking a two-by-four to the economy and breaking the back of inflation, twice.
Once in 1979, leading to a mild 6 month reccession. And then again in 1981, causing a more severe recession lasting ~18 months. Unemployment would peak in 1982 at 10.8% and inflation would fall to as low as 3.4% by the time Volcker left office in 1987. His trusty two-by-four would go down in history; despite not being well recived at the time. Looking back, in 1983, he would remark:
“The pain we have suffered would have been for nought—and we would only be putting off until some later time an even more painful day of reckoning”.
In hindsight, he did what had to be done. The pain it caused in the interim was to protect the country from even graver circumstances down the line. At least, that’s the idea; we will never truly know what would have happened if he took a weaker stance on inflation.
Let's say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every time you got an interest payment, you used it to buy more of that same bond. At the end of 1998, with long-term governments by then selling at 5%, you would have had $8,181,219 and would have earned an annual return of more than 13%. That 13% annual return is better than stocks have done in a great many 17-year periods in history - in most 17-year periods, in fact. It was a helluva result, and from none other than a stodgy bond. The power of interest rates had the effect of pushing up equities as well, though other things that we will get to pushed additionally. And so here's what equities did in that same 17 years: If you'd invested $1 million in the Dow on Nov. 16, 1981, and reinvested all dividends, you'd have had $19,720,112 on Dec. 31, 1998. And your annual return would have been 19%. The increase in equity values since 1981 beats anything you can find in history. This increase even surpasses what you would have realized if you'd bought stocks in 1932, at their Depression bottom - on its lowest day, July 8, 1932, the Dow closed at 41.22 - and held them for 17 years.