Even in frothy markets, much like today's U.S. stock market, there are always opportunities. But the U.S. stock market is trading at historical highs—just see the Shiller PE or the Buffett Indicator—and it's growing more difficult to ignore the potential impact to equity investors.
To understand where we are today, it's useful to look at history. In November 1999, Warren Buffett gave, what I consider, the best macro discussion of the U.S. stock market.
In true Buffett fashion, he kept the discussion impressively simple. He focused his talk primarily on two important variables that affect investment results: government interest rates and after-tax corporate profits.
Buffett stated that for equities to provide a good return from 1999 forward, two things would have to happen with these variables: the first was that government interest rates must fall, and the second was that corporate profitability in relation to gross domestic product (GDP) must rise. With interest rates at roughly 6%, Buffett found it highly improbable that interest rates would fall. Likewise, with corporate profits in relation to GDP also at 6%, he found it unlikely that corporate profits as a percent of GDP could hold at anything above 6% given historical trends.
His conclusion was logical based on historical facts, but boy was he wrong.
From November 1999, government interest rates dropped from roughly 6% to a low of 0.5% in 2020. After-tax corporate profits in relation to GDP grew to over 10% and has remained there more or less over the past decade. (Certainly, the decline in corporate tax rates in the U.S. have helped as the top bracket fell 53% to 35% in 1993, and then to 21% in 2018.)
Today, interest rates sit at roughly 4%, and corporate profits as a percent of GDP is over 11%, all while corporate taxes are at historical lows. Given this, I can't see how stocks in aggregate fare out well in the next decade or so from today's levels. I think it's more probable that interest rates will rise given the current U.S. deficit. I also believe corporate profits are overstated, particularly in the tech industry where companies are manipulating their accounting assumptions to increase apparent profits. Consequently, I can't envision that corporate profits as a percent of GDP remains at today's high; it's likely to fall back to the 4% to 6% range it historically bobbed around.
What about artificial intelligence? Won't companies become more productive and, therefore, increase profits? Maybe. But like Buffett points out in his talk, despite transformative industries such as autos or airlines, corporate profits as a percent of GDP still only averaged 4% to 6%.
So what does this all mean for equity investors today? To quote Buffett:
To understand where we are today, it's useful to look at history. In November 1999, Warren Buffett gave, what I consider, the best macro discussion of the U.S. stock market.
In true Buffett fashion, he kept the discussion impressively simple. He focused his talk primarily on two important variables that affect investment results: government interest rates and after-tax corporate profits.
Buffett stated that for equities to provide a good return from 1999 forward, two things would have to happen with these variables: the first was that government interest rates must fall, and the second was that corporate profitability in relation to gross domestic product (GDP) must rise. With interest rates at roughly 6%, Buffett found it highly improbable that interest rates would fall. Likewise, with corporate profits in relation to GDP also at 6%, he found it unlikely that corporate profits as a percent of GDP could hold at anything above 6% given historical trends.
His conclusion was logical based on historical facts, but boy was he wrong.
From November 1999, government interest rates dropped from roughly 6% to a low of 0.5% in 2020. After-tax corporate profits in relation to GDP grew to over 10% and has remained there more or less over the past decade. (Certainly, the decline in corporate tax rates in the U.S. have helped as the top bracket fell 53% to 35% in 1993, and then to 21% in 2018.)
Today, interest rates sit at roughly 4%, and corporate profits as a percent of GDP is over 11%, all while corporate taxes are at historical lows. Given this, I can't see how stocks in aggregate fare out well in the next decade or so from today's levels. I think it's more probable that interest rates will rise given the current U.S. deficit. I also believe corporate profits are overstated, particularly in the tech industry where companies are manipulating their accounting assumptions to increase apparent profits. Consequently, I can't envision that corporate profits as a percent of GDP remains at today's high; it's likely to fall back to the 4% to 6% range it historically bobbed around.
What about artificial intelligence? Won't companies become more productive and, therefore, increase profits? Maybe. But like Buffett points out in his talk, despite transformative industries such as autos or airlines, corporate profits as a percent of GDP still only averaged 4% to 6%.
So what does this all mean for equity investors today? To quote Buffett:
I see them entering a world in which the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment—but only because they started out expecting too much.