On the final weekend in February, Warren Buffett released his 2016 letter to Berkshire Hathaway shareholders. It is a sought after annual letter that is widely read by both professional and novice investors. Regular readers of this letter know Buffett is persistently optimistic about the prospects of the U.S. economy. His support to the dynamism of the U.S. economy reached new heights in the most recent letter. Days later he participated in an interview on CNBC. When asked about the high valuation of the stock market, Buffett responded by saying it was not in a bubble because interest rates were low. He went so far as to say when measured against interest rates, stocks actually are cheap relative to historic valuations. He explained (emphasis added):
“Now, if interest rates were 7 or 8 percent then these prices would look exceptionally high. But you have to measure, you know, you measure everything against interest rates, basically, and interest rates act like gravity on valuation.” – Warren Buffett (February 27, 2017)
Does Growth Matter?
I was extremely surprised to hear Buffett say this. Spending much of my career doing valuation work on both private and public equities, I very well understand that interest rates are an important driver of valuations. When interest rates are low, then this would contribute to a higher valuation but this has its limits. Let me explain.
In a laboratory where you conduct experiments by changing one thing while holding everything else constant, low interest rates raise valuations, as Buffett correctly asserted. In the real world where things cannot be held constant, low interest rates also means low growth. When you factor in low growth, which Buffett ignored, valuations subsequently decrease. Hence, low growth is a countervailing force against low interest rates.
Since the end of the Global Financial Crisis, the U.S. economy has recovered at the slowest rate of GDP growth since WWII. Much of this has to do with low productivity. The former Chairman of the Federal Reserve, Alan Greenspan, has spoken extensively about the relationship between productivity and growth. Less than three months ago in an interview with Bloomberg, Greenspan explained (emphasis added):
A necessary condition for economic growth is that output per hour grows at a rate probably close to 2 percent. We’re now under 0.5 percent, meaning we’re essentially for the last five years have been growing scarcely at all with respect to output per hour. – Alan Greenspan (December 15, 2016)
What’s Risk Got to Do with It?
If you focus exclusively on interest rates, as Buffett apparently did, what you basically have is the Fed Model. It provides a very easy use approach to equity valuation. It is commonly used to compare the earnings yield (i.e. inverse of the P/E multiple) of the S&P 500 vs. the 10-year treasury yield. When the earnings yield is greater than the treasury yield, equities are said to be cheap.
The problem with this overly simplistic approach is that it ignores growth, as discussed earlier. It also ignores the risk premium of equities, which is another very important driver in valuations. Why? Corporate equities are inherently riskier than government bonds. Corporations go bankrupt all the time, whereas the chances of the U.S. government defaulting on its treasury bonds are much, much slimmer. Comparing the earnings yield against the treasury yield without accounting for the risk premium of equities is like comparing a watermelon to a grape.
It was an Illusion
The topic of the Fed Model has also been long discredited. Economist and investment manager Cliff Asness attained his Ph.D. at the University of Chicago under the supervision of Nobel Laureate and asset pricing expert Eugene Fama. In 2002, Asness published a paper in the Journal of Portfolio Management titled “Fight the Fed Model” to argue that the whole thing was a case of something called money illusion. Instead of discussing growth, as I did earlier, he focused on inflation. He explained:
It is true that all-else-equal a falling discount rate . . . raises the current price. All else is not equal, though. If, when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates. [Lower discount rates] are applied to lower expected cash flows. The typical ‘common sense’ behind the Fed Model ignores this power counter-argument. – Cliff Asness (2002)
In other words, investors can get confused between real and nominal rates. In fact, they do. Asness found, “. . . that investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower and vice versa.” This phenomenon is temporary though. Investors seem to figure out this money illusion. This overshoot in valuation corrects itself eventually. According to Asness, (emphasis added), “Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates.”
If valuations are cheap right now because interest rates are so low, then it would follow, using Buffett’s logic, that lower interest rates would contribute to even higher valuations. Let’s see what history has to say about this.
Illustrated in the 100+ year graph above is a comparison of: 1) 10-year treasury yields (blue bars), and 2) Cyclically-Adjusted Price-to-Earnings (“CAPE”) ratio (yellow line) of the S&P Composite Index. The CAPE ratio was devised by Yale economics professor Robert Shiller, who won a Nobel prize in 2013 for his work in asset pricing. As you can see, the CAPE ratio was very recently at 28.7x. The only other times the U.S. stock market was more expensive was: 1) in the Roaring Twenties (preceding the Great Depression) and, 2) the Tech Bubble. Both ended really badly.
The 10-year treasury yield was recently at 2.5%. Have it ever been lower? Indeed, it has. The economic downturn caused by the Global Financial Crisis is often referred to as the Great Recession and is commonly compared to the Great Depression. It is no coincidence that interest rates right now are comparable to that era. Even though the Great Depression had already ended by 1941, 10-year treasury yields decreased to a 20th century low of 2.0% early that year. Interest rates were very, very low but the valuation of the S&P Composite Index, as measured by the CAPE ratio, was at 13.9x, which was less than half of what it is today.
The point I am trying to make here is that interest rates do not alone drive valuation. Growth and the equity risk premium are also important factors. In the case of 1941, the equity risk premium can overshadow both: 1) low interest rates and 2) high economic growth. Economic historian and investment strategist Russell Napier published in 2005 a book titled, “Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms”. It was in that book he studied four of Wall Street’s greatest bear markets. With respect to the years leading up to and during 1941, Napier wrote (emphasis added)
From the low in 1938, S&P Composite Index earnings doubled by December 1941, but the DJIA was unchanged. In an era of waning confidence in the economic future, equity price could ignore even the strongest of earnings recoveries. – Russell Napier (2005)
Don’t Fight the Fed
In his interview less than two weeks ago with CNBC, Buffett did make a concession that would unravel his claim that equities were cheap: higher interest rates. He specifically said (emphasis added):
But the risk always is, is that — that interest rates go up a lot, and that brings stocks down. But I would say this, if the ten-year stays at 230, and they would stay there for ten years, you would regret very much not having bought stocks now. – Warren Buffett (February 27, 2017)
I have read and listened to a lot of Buffett’s writings and interviews throughout my career. It is clear to me he understands the concept of reversion to the mean. It is also clear to me he does not trust forecasts. With that being said, I am dumbfounded by the above quote where he suggests 10-year treasury yields could stay at an abnormally low rate of 2.30% over the next decade!
Let me start out by stating the obvious. Interest rates are going up. It has been widely reported that the federal funds rate (“FFR”) will very likely increase next week when the Federal Reserve’s Federal Open Markets Committee meets. It will very likely prove to be the 2nd rate hike in only 3 months. A big part of the reason why interest rates are rising is because inflationary pressures are present, particularly in wages. In fact, it was former Federal Reserve chairman Alan Greenspan who only 4 months ago said in an interview with Bloomberg that (emphasis added): “We are moving into the very early stages of inflation acceleration.” Banks are also tightening lending, which foreshadows higher interest rates, too.
Furthermore, I assert that the Federal Reserve will need to raise interest rates faster than expected. Let me tell you why. One of the key ways the Federal Reserve controls interest rates is by adjusting the FFR. Since the Global Financial Crisis and its three rounds of quantitative easing, the Federal Reserve has pushed down and maintained the FFR near zero percent. On the face of it, this is an abnormally low rate. That’s just intuition though. How can this abnormality be measured?
As illustrated in the 40+ year graph above, the FFR during normal times is closely tied to the 2-year treasury yield. For the 30+ year period before the Global Financial Crisis, the FFR has normally been around 91% or 0.91x (yellow dotted line) of the 2-year treasury yield. The FFR though does stray from the 2-year treasury yield, particularly immediately before and after recessions (grey shaded areas).
If you look closely, you will see that the ratio between the FFR and 2-year treasury yield (“Yield Ratio”) is normally above the yellow dotted line before recessions. This illustrates the Federal Reserve’s attempts to raise interest rates to fight inflation, which is common near the end of business cycles. The Yield Ratio is below the yellow dotted line after recessions begin, which shows the Federal Reserve’s attempt to spur economic growth via lower interest rates. In the 30+ year period demonstrated above, the Yield Ratio is normally (i.e. within two standard deviations) between 58% or 0.58x (red dotted line) and 125% or 1.25x (green dotted line).
Since the Global Financial Crisis and the Great Recession, the Yield Ratio has been as low at 8% or 0.08x. Though it has risen to its current level of 51% or 0.51x, it is still far off from its average of 91% or 0.91x. Given the current 2-year treasury yield of 1.32%, this implies the FFR should increase to approximately 1.20% from its current level of 0.66%. The assumes the Yield Ratio relationship reverts to its mean. It can actually go higher.
In the above shown monetary tightening cycles, the Yield Ratio approaches the green dotted line. Given the U.S. is currently in what sure looks like the beginning of another monetary tightening cycle, this implies the FFR should increase to approximately 1.65% from its current level of 0.66%. If the 2-year treasury yield rises beyond its current rate of 1.32%, then watch out. Buffett’s concession that higher interest rates will bring down stock prices will look more like a confession.
Warren Buffett’s assertion that equites are cheap makes no sense. He focused exclusively on an assumption that low interest rates could remain that way for another decade. This ignored growth, which is a vital input in valuation and currently remains low. Buffett also ignored the equity risk premium, which again is an another vital input in valuation. Looking at a time in history when interest rates were actually lower and growth was strong, valuation of the U.S. stock market in 1941 was actually less than half if what it is now due to concerns around risk.
In all fairness, Buffett’s concession that higher interest rates will bring down stock prices is something he and I can agree on. Too bad he spent very little time considering that possibility. Right now, the Federal Reserve has begun another monetary tightening cycle. When this happens, the Federal Reserve normally finds itself raising its FFR faster than normal before it finds itself in another recession.
Whether or not you find Warren Buffett’s assertion about equities being cheap is plainly wrong, please consult with an investment fiduciary before making any investment decisions.
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