Dear fellow investors,
It is hard to think about 1981, my first full year in the investment business.Three-month Treasury bills were paying 18 percent, longer-term Treasury bonds yielded 15 percent to maturity and cheap stocks got 20 percent cheaper. In the summer of 1981, we saw a stock market decline from an already depressed market trading at eight-times after-tax profits down closer to six times. Participation in the stock market was down to 13.2 percent of U.S. household financial assets at the market bottom in 1982.
Inflation was high, gold was popular and energy stocks peaked at 28 percent of the S&P 500 Index. Investors were sensibly choosing to earn interest or make a speculative bet on high inflation. Companies sold shares to raise capital because the banks had to charge a 20 percent rate for its “prime” customers. Equity was dear, but it was the source of capital in the absence of borrowing sources. Horrid stock markets for 15 years and a 30-year bond bear market made investors feel brainless.
Fast forward to today. We are in a nearly polar opposite circumstance. Interest rates range from 0.5 percent to 3 percent on Treasury debt instruments. The major stock indexes trade for 20 to 28 times after-tax profits. Companies rarely sell shares on initial or secondary public offerings, because money can be borrowed cheaply and/or alternative investment funds are drunk with excess cash from institutions. These institutions are chasing private equity and venture capital bonanzas in the privately held and highly illiquid markets. The number of public companies in the Wilshire 5000 has busted the use of the name because there are only 3,600 of them left. Participation in the stock market was up to 38 percent of household financial assets, before the rally in 2017. It appears we are confusing brains with a bull market. ( Source: Federal Reserve Board. Quarterly Data 1951-12-31 to 2016-12-31.)
Two of the finest investors of all time, Warren Buffett and Jeremy Grantham, are pointing out that today’s low interest rates justify the prices of the average S&P 500 stock. Grantham insinuated recently that corporate profits as a percentage of GDP might have hit a permanently higher plateau, even though his long-term market forecast has been too bearish on stocks for three years. Furthermore, Buffett is ignoring the bearish advice he gave in his talk in the summer of 1999 at the Allen and Co. M&A boondoggle. In his talk, he examined stock prices in relationship to interest rates and corporate profits. The rates are lower now and the corporate profits as a percentage of GDP are much higher today than in 1999. It appears we are confusing brains with a bull market.
Growth and momentum investors have clobbered value managers. Price-to-earnings ratios don’t seem to matter much and it is hard to tell what companies are actually earning because of all the equity comp not included in what is called “operating income.” The low-cost S&P 500 Index funds, so successfully promoted by their wholesaler-in-chief, John Bogle, cause anyone to automatically appear genius. The S&P 500 hasn’t had a down total-return year since 2008 and is loaded with the large growth and momentum stocks, which have been on fire.