Buried beneath the recent news cycle of NFL player protests and North Korean posturing was a prescient prediction from arguably the best investor the world has ever known, Warren Buffet. The Oracle of Omaha recently prophesied that the well-known Dow Jones Industrial Average would reach 1,000,000 within the next 100 years. Outrageous? Unlikely? Hardly.
Coming from a current level of around 22,300, this may seem like crazy talk. The target number sounds ridiculously big, but the simple math proves that the Dow would only need to return ~4% annually in order to hit Buffet’s 7-digit bogey. Certainly reasonable if history is any guide.
For some context, if we took the reaction from brokers on a ticker tape littered floor of the New York Consolidated Stock Exchange in 1917 that the Dow (then at 81) would be at 22,300 in 100 years, it would have produced similar chuckles of doubt. Why?
In part, it has to do with how we process and filter the sheer mass of information inundating our gray matter every minute of every day. If we had to deeply contemplate and weigh every minuscule decision and data input, we would never leave the house. Instead, we’ve developed decision shortcuts, which help us speed up data processing – unfortunately often at the expense of accuracy.
In the investing world, these take the form of biases – tendencies that lead us to quick, but quasi-logical conclusions based on available data.
Back to Dow 1 million. Our natural, knee-jerk reaction to such a prediction (from a current level of 22,300) is to anchor on the relatively smaller base number and to hence doubt the validity of the forecast.
The Anchoring Bias is a very well know investor behavior and can foil a long-term financial plan in a number of ways. Not only can it lead to doubts about future returns, but it can influence how an investor thinks about a losing position. For instance, logically, it might make sense to sell a stock that is down (maybe the company’s sales have cratered), but by anchoring on a recent higher price, investors will ‘hold on’ hoping to regain that high price.
Investor biases are not just the bane of regular investors, but also financial professionals. We see this all the time in what is touted as ‘advice’ based on sound facts. Take the below headlines from well-known, institutional firms (names withheld) this past week:
“___ sees trouble for stocks, brace for a 4% to 8% slide before year’s end”
“…strategist says bear market could start next year after a surge higher”
Both are classic examples of another investor bias – Recency Bias.
At best, these folks are making a WAG (wild-a$$-guess – a technical industry term); at worst they are spooking investors to trade out of stocks and possibly abandon a well-laid financial plan. Their rationale is simply that stocks have run higher the past few years. They are putting more weight on what has happened recently, rather than doing the research work and connecting the dots. Nobody can accurately predict what stocks are going to do over the next three months. However, go out beyond 10 years (and especially 100 years) and the cone of possible outcomes becomes increasingly more narrow and clear.
The current drumbeat is that stocks are expensive, the market has been running for almost nine years and stocks can’t go higher. Almost nobody likes this market. We like it that way.
It’s certainly true that we are at the high end of the S&P 500’s price/earnings valuation (PE) range, but we believe you can’t just take one valuation measure in isolation. It’s also important to remember that all investments are relative to other current opportunities.
With bond yields low across all of the developed world and inflation tame and stable, stocks should be valued at the higher end of their range. This is because future earnings are worth more when discounted at low risk-free rates. Not only that, but it’s entirely feasible that we have entered into an era of generally higher valuations for stocks, enabled by dynamics such as deflationary pressures from the disruptive ‘Amazon effect’ on retail, the globalization of markets and a revived push into technologies like artificial intelligence that could drive efficiencies and economic growth.
Notice in the above chart that since around 1990 we have spent more time above the long-term average PE of ~15 and that the trend is higher PEs. This period happens to start with the U.S. economy’s last trip above 6% inflation and continues through the Great Moderation in inflation rates and corresponding stable macroeconomic policy. This in stark contrast to the inflation spikes of the 70s and 80s and the “go-stop” monetary policy of that day which produced volatile, short business cycles through vacillating periods of prolonged easy money and over tightening. More stable and lower inflation, along with more telegraphed, less volatile monetary policy minimizes what used to be a major risk component to investors and firms and may be one reason for the current higher valuation regime.
Investors continue to use the same traditional economic theories and valuation metrics to explain an economy and market that are vastly different than those of just 10 short years ago. Does a price/earnings ratio on the Dow today mean the same as in 1917, or even just a decade ago? Of the 30 current Dow Jones Industrial Average stocks, only one would be familiar to those traders on the floor of the NY Comp Stock Exchange in 1917, good ol’ General Electric.
In 1917, the 10-year bond was yielding 4.23% and inflation was running at 19.66% due to resources being diverted to World War I manufacturing efforts. The market was trading at a price to earnings ratio of 6.34 compared to ~25 today. Were stocks a bargain back then because of this low valuation? Not necessarily. It was a different economic environment and a challenging time, given so much uncertainty surrounding input prices and by extension, corporate profit margins. Stocks essentially stayed flat for another eight years before heading higher on the back of an invigorated middle class, a changed public perception of the stock market and the ability to more efficiently trade stocks on new stock market exchanges.
Coming full circle after a small dose of historical perspective, BSW respects traditional measures of valuation; we reference the past to learn what may or may not happen in the future and, importantly, we try very hard to minimize the negative effects of investor biases on our thinking – and by extension, our investment actions. We seek to reduce our biases by not taking headlines at face value but instead we search for relevant or new disconfirming evidence. We dive deep into the facts and the numbers that support different investment thesis. We have a seven person Investment Policy Committee whose processes and guidelines keep each other in check by watching for signs of bias-creep in our proposals and counter-arguments.
The bottom line for us (after triangulating on the facts) is that there is no evidence of an imminent downturn in stocks. There is no reason that this can’t be the longest bull market in history. There is no reason why stocks can’t keep going higher, much higher – especially given the not-so-secret investment ingredient of time.
We are maintaining our overweight positions in the most attractive areas of the world: emerging markets such as China, the Philippines, and India; as well as foreign developed countries such as Germany, France, UK and Japan.
Our growth benchmark, the All Country World Index (ACWI) is up a whopping 17.25% year to date through September. Despite this being a very generous return figure, we see more solid returns ahead based on the current global coordinated expansion, low-interest rates, and moderate inflation.
Thanks for reading.
It was nice to see many of you at our recent Client Event. Thanks to all of our clients, colleagues, and friends for making the past 25 years at BSW so rewarding on so many levels!
Director Public Investments