Does Buffett Really Think The Stock Market Is Cheap?

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, Ill also discuss Warren Buffetts recent comment that the stock market is still cheap.

March Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of March 2017 were as follows:

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

In contrast to our competitors, MoneyGeeks Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free regular membership.

In March, MoneyGeeks portfolios underperformed its competitors. This was largely due to BRK-B, which went down by 2.7%. Note that the performance metrics dont take the recent addition of CGL-C.TO into account. They will do so starting this month.

As the stock market has continued climbing in these last few months, many prominent economists and investors have started sounding the alarm on the valuation of the market. For example, Nobel prize winning economist Robert Shiller has called the valuation very high based on a metric called CAPE, which measures the long term profitability of U.S. companies. Howard Marks, a very prominent investor, has recently called the market borderline richly valued.

However, theres one prominent investor who has bucked that trend, and that investor is Warren Buffett. In a recent CNBC interview, Buffett said that stocks actually are on the cheap side. But rather than taking his word at face value and pouring all of our money into stocks, I think its important to gain a deeper understanding of what he means. When we do this, we find that his opinion is actually a lot more nuanced than it may seem at first.

The key to understanding Buffetts logic is his assertion that we should always measure the value of investments against prevailing interest rates. Indeed, he said that if interest rates were at 7 or 8 percent today, stocks prices would look exceptionally high.

The reason we should factor in interest rate is due to opportunity cost. To explain this concept, lets say that long term U.S. government bonds yield 7% per year, whereas you expect stocks to return 5% per year. Then, if you invested in stocks instead of government bonds, you would achieve about 2% per year less in returns. This 2% is the opportunity cost, and youd probably want to invest in government bonds instead because the opportunity cost is high.

On the other hand, lets say that the government bonds yield 3% per year while you expect stocks to return 5% per year. Then, the opportunity cost is negative, so you may (but not necessarily - more on this later) want to invest in stocks instead of bonds.

Now that we understand why we should consider interest rates, lets examine where we stand today. Measuring the yield on government bonds is easy because many media outlets publish those figures. For example CNBC reports that U.S. government bonds that mature in 30 years currently yield about 3% per year.

Measuring the likely return of stocks, on the other hand, is much more difficult, though not impossible. Ive previously written about one such method, for example. The largest hedge fund in the world,Bridgewater Associates, aggregates several of these forecasts, and its founder said last year that he expects stocks to return roughly 4% per year going forward. I dont expect his firms forecasts to have changed drastically since then, though I suspect the predicted rate of return is a bit lower now.

Even if we assume that stocks will return about 3.5% per year in the long term, thats still a higher rate of return than the 3% per year we can get from investing in 30-year U.S. government bonds. It is for this reason that Buffett thinks stocks are still cheap.

However, its important to note that not everybody agrees with this assessment. Because stocks are generally considered riskier than government bonds, investors usually require a higher rate of return on stocks to compensate. If investors think that the higher risk is worth 2% per year in returns, then they will prefer government bonds to stocks as long as stocks will return less than 3 + 2 = 5% per year. It is for this reason that people like Robert Shiller say the stock market is overpriced.

But as he often does, Warren Buffett takes a different view on stock market risk than most other investors. In his view, the U.S. stock market as a whole is no more risky than long term government bonds when the risk is viewed over the very long run (e.g. 30 years). His view is supported by empirical research, as laid out for example in Jeremy Siegels book called Stocks for the Long Run.

Since he sees little difference in risk profiles of stocks and bonds, Buffett tends to compare long term stock market forecasts to government bond yields without making any adjustments for risk. He would then deem stocks to be cheap if their forecasted returns exceed bond yields.

While we can certainly understand Buffetts reasons for calling stocks cheap, we should also keep in mind that because of his methodology, his opinion on the value of the stock market can change quickly. For example, if bond yields go up by 1% to 4% per year, then we could be in a situation where bond yields exceed forecasted stock returns. If this were to occur, Buffett would probably stop calling the stock market cheap. If bond yields rise further and go up to 6 or 7%, Buffett would consider the stock market to be very expensive.

Theres a reasonable chance that bond yields will go up by a percentage or more. This could happen if, for example, the U.S. government runs a big budget deficit and causes inflation to go higher. While stock prices are somewhat protected from inflation, theyre not totally immune to its effects, and higher interest rates are one of the mechanisms through which inflation can actually hurt stocks.

In summary, Buffetts assertion that stocks are cheap hinges heavily on the fact that interest rates today are exceptionally low. If interest rates rise, stocks could suddenly start to look overvalued. I believe this supports my recent decision to diversify from stocks.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.