I spoke to a medical doctor recently. In our conversation, he asked me if it was too late for him to get into some hot tech stocks that have been pushing up the stock market. He also said he is looking to increase the equity allocation of his investment portfolio. I wasn’t too surprised to hear this. Investor sentiment has been bullish.
Brokerage firm Charles Schwab reported last month that new account openings were growing. They are at levels not seen since the exuberant times of the Tech Bubble. Brokerage firm E*TRADE reported last month nearly a third of millennial investors surveyed plan to move out of cash and into new stock positions over the next six months. Seems to me inexperienced investors are making the same mistake as their parents did about 17 or 18 years ago when online trading became available to the masses. If you don’t know what I am referring to, then please read on.
Investing Requires Zero Qualifications
About 18 years ago, Warren Buffett made a speech at the Allen & Company Sun Valley Conference. Those who attended were some of the world’s leaders in business, politics, philanthropy and art. Attendees also included many young tech entrepreneurs that amassed vast paper profits from taking their fledgling internet companies public. In Buffett’s speech, he preached to the tech entrepreneurs about how extravagantly overvalued their stocks were. He started his speech with the following (emphasis added):
“I will be talking about pricing stocks . . . In the short run, the market is a voting machine. In the long run, it’s a weighing machine. Weight counts eventually. But votes count in the short term. And it’s a very undemocratic way of voting. Unfortunately, they have no literacy tests in terms of voting qualifications, as you’ve all learned.” – Warren Buffett (July 1999)
After going into lessons in market history and joking about assassinating aviation pioneer Orville Wright, Buffett made his message clear. Despite hopes for a new paradigm driven by the internet, the value of the stock market could only reflect the output of the economy. According to Buffett’s biographer (emphasis added):
The audience took his point, which was that people who bought Internet stocks were about to get screwed. They sat in stony silence. Nobody laughed. Nobody chuckled or snickered or guffawed. – Alice Shroeder, Warren Buffett’s biographer (September 2008)
The lack of financial literacy qualifications required to be an investor during the Tech Bubble proved devastating. After peaking in March 2000, the S&P 500 crashed by 50% over the next 31 months. The technology-heavy NASDAQ fared worst.
Playing with Fire
As the Tech Bubble collapsed, Buffett revealed in a Forbes magazine article in December 2001 how he values the stock market. As indicated above, he believes the value of the stock market is best reflected by the output of the economy. He does this by calculating the ratio of the market value of a county’s stock market against its gross national product (“GNP”). According to Buffett (emphasis added): “The ratio . . . is probably the best single measure of where valuations stand at any given moment.” This is illustrated in the graph below.
The Tech Bubble peaked in early-2000 when the ratio reached as high as 180%. According to Buffett, this was much too high a level fraught with risk. He wrote (emphasis added):
If the ratio approaches 200% – as it did in 1999 and a part of 2000 – you are playing with fire. – Warren Buffett (December 2001)
Waiting for Fat Pitches
Looks like the history may be repeating itself. Data from the Federal Reserve and the Bureau of Economic Analysis shows the ratio was most recently at 172% (yellow bar). This is the third highest valuation level (based on quarterly data) looking back 60+ years. That ratio is behind only two other periods: 1) late-1999, and 2) early-2000, which marked the height of the irrationally exuberant Tech Bubble before it collapsed in spectacular fashion.
This may explain why the investment portfolio at Buffett’s company, Berkshire Hathaway, most recently reported it had almost US$100 billion in cash. This equates to almost 40% of the investment portfolio. It is times like these when it may prove opportunistic to have dry powder to get ready for those rare buying opportunities that Buffett calls “fat pitches.”
Buffett said in 1999 that the stock market in the short-run is a voting machine and its voters “unfortunately” are not required to be financially literate. He also said it is a weighing machine in the long-run that is grounded by economic output. The Tech Bubble and its collapse proved him correct. Given Buffett’s valuation ratio is once again approaching 200%, it sure looks like young, inexperienced and financially illiterate investors are once again pushing stock prices up to unstainable levels like their parents did during the Tech Bubble. Buffett on the other hand is maintaining a large cash position, presumably to avoid “playing with fire” and to wait for “fat pitches.” Perhaps you should consider doing the same.
Whether or not you believe investors are once again playing with fire, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, Meritocracy Capital Partners would welcome the opportunity to serve as your partner in protecting and growing your and your family’s wealth.
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