The Warren Buffett Approach: Be Realistic About Future Returns

I’ll never forget this article Warren Buffett wrote for Fortune in 1999.

I was a senior in college… and already dreaming of making millions in the stock market. It was the 1990s, and anything ending with “dot com” was enough to cast dollar signs over your eyes.

So when Warren Buffett — a man I considered a hero — had the audacity to say that stock returns going forward would be disappointing, I felt betrayed… even insulted. Clearly the Sage of Omaha had lost his touch, I thought.

Naturally, I didn’t follow his advice, and I lost a lot of money as a result in the crash that quickly followed.

16 years later, his words are every bit as insightful today as they were then. Buffett argued that, in order for investors to earn anything close to historical returns in the market, the following two conditions would have to hold:

  • Interest rates must fall further.
  • Corporate profitability in relation to GDP must rise.

The funny thing is, when Buffett wrote this in 1999, he didn’t consider either of those scenarios likely. At the very least, he knew they weren’t sustainable…

He believed that if interest rates fell from 6% to 3%, that factor alone could double the value of common stocks. Rates have obviously fallen a lot further than that, but while the market hasn’t exactly doubled from ’99 levels, lower rates have allowed for much higher stock valuations.

As for the second point, Buffett said: “You have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.

As you can see in the chart, courtesy of the St. Louis Fed, corporate profits have now nearly doubled those levels:

fredgraph

But while Buffett might have been a little off on the numbers, his point is still a valid one. Falling bond yields can’t prop the market up forever, and companies cannot continue to take an ever-bigger slice of the economic pie.

Today, market rates across the yield curve are near historic lows. They cannot realistically go much lower, unless temporarily during a crisis.

And at the same time, corporate profits as a percentage of GDP are at all-time highs.

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None of this means the market is due to crash tomorrow, but it tells me that we should have realistic expectations about future returns. A strategy of buying and holding U.S. equities isn’t likely to offer much in the way of returns going forward.

If you’re going to earn anything resembling a respectable return, plan on taking a more tactical approach such as with Adam’s Max Profit Alert and looking outside your normal comfort zones.

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Charles

 

Categories: Markets

About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.