General Market View

April 29, 1999

Before the 1990s boom in equity prices, a 3% dividend yield was considered a harbinger of a market top. The long term average yield is over 4%. No doubt the current yield of 1.2% is a reflection of changes in corporate governance as well extremely high stock prices. But here's an interesting observation. The current EARNINGS YIELD on the S&P500 is LESS than 3%. That means that if every penny (instead of the average of about 55%) of earnings was paid out in dividends, the yield would still be flashing red hot danger according to traditional valuation standards. Furthermore, earnings quality is currently poor. Warren Buffett elaborated on this in his most recent shareholder letter. So it's unlikely that the full amount of earnings could be paid out without a deterioration in their balance sheets even if the companies wanted to. I'm afraid to think about what these prices are a harbinger of!

As for the values, aggregate "blue chip" indices are discounting low interest rates, low inflation, late business cycle margins, and high return on equity as if they are a permanent and sustainable state of affairs. For that set of assumptions, investors are receiving a discounted rate of return only slightly above safer securities like bonds.

I continue to believe that this is a reckless set of assumptions on which to base the purchase of a business. It's even more reckless in light of the recent slowdown in earnings growth, unresolved economic problems around the world, and a narrowing of profit margins in some industries at home.

The current PE of over 35 times earnings is equivalent to an earnings yield of around 2.8%. It comes at a time of high profit margins that could easily decline. This 2.8% yield is significantly lower than the yield available on government and corporate bonds. This implies that a rapid growth in profits will be needed over the next couple of years to justify these prices. That type of growth does not seem likely at this point in the business cycle.

Viewed from a longer term perspective, corporate profit growth tends to track the growth in nominal GDP. The current estimate for sustainable economic growth in the U.S. is between 2.5%-3%. Inflation expectations for the next 10-20 years are somewhere between 1%-2%. This works out to a range of 3.5%-5% long term nominal GDP growth. With the current dividend yield on the S&P500 of around 1.2%, an investor will receive a total return of 4.7%-6.2% from dividends and their growth (assuming at steady PE). To this we should add some share repurchases that will enhance E.P.S. progress (less than 1% from these levels). A reasonable estimate of future long term stock returns from these levels might be 5.5%-7%.

It should be clear that future returns are almost certain to be well below the long-term average of around 10%. If traditional PEs return, (even gradually), "blue chip" returns will be negative over the next decade. If corporate profitability declines to more average levels over time, the returns will be even worse. There could also be a significant and rapid PE contraction along the way to more average levels. As much as a 60% bear market is a possibility from here. There is simply NO MARGIN OF SAFETY at current prices and margin of safety is the hallmark of successful investment.

In addition, there's a good possibility that some of our robust economic activity is tied to the outsized capital gains of recent years. 20% annual capital gains is helping drive consumption, making pension funding easier, generating excess capital gains taxes for governments, and driving profits for banks and brokers. Sustaining this is virtually impossible. That means that many businesses that appear reasonably priced based on current earnings may not be. In this environment the income streams are somewhat suspect. Outside the S&P500 valuations in many areas appear reasonable. Some are even attractive. However, I believe a greater margin of safety should be required before investing. There are many unknowns about how these general financial excesses will impact the economy when and if they burst.

Another interesting phenomenon is that some companies are leveraging their balance sheet in order to repurchase shares. This is an unsustainable process that could prove quite foolish even though it seems sensible at the height of prosperity. There are a couple of reasons for this activity besides questionable judgment. As stock prices rise faster than earnings, fewer shares can be repurchased from the available free cash flow. A slowdown in the rate of share repurchases compared to recent years means that E.P.S. growth will be slower even if all else is equal. The generous stock option packages granted in recent years are making it all the more difficult to reduce those outstanding shares. As these options are exercised, it requires stock repurchases just to avoid dilution.

The greatest excesses appear to be located in technology, the internet, and some financial institutions. The stocks may continue to perform well due to the focus on price momentum, but the prices are out of line with any reasonable assessment of their long term earnings power and business risks. Technology companies face constant business challenges. Many of today's leaders won't even be here 10-15 years from now. Yet their stock prices are discounting rapid earnings growth for many years to come. The above average profitability of many banks, brokers and dealers is tied to the high level of public participation in the market, enormous merger and acquisition activity, runaway trading profits made possible by the environment, and a leveraged financial system. We've seen these conditions before, though never on this scale. It is unlikely to last. That means investors are paying top dollar for top earnings. Not a very good idea.

All I can add is that when others are behaving recklessly it is time to be doubly cautious. Personally, I have never seen greed and recklessness like we are seeing at present.

Lastly, I continue to believe that the Federal Reserve has made an enormous error by focusing its attention on benign CPI reports and ignoring the growing financial asset inflation. While it's true that generally these sorts things are best left to markets, the current excesses would not be possible without a very accommodative monetary policy both here and abroad. In addition, we are not talking about mild deviations from the average. These are far and away the highest aggregate stock prices in history based on every standard criteria of value that I am aware of. In addition, intentionally or not, by its actions the Fed has nurtured the idea that it will always be there in case there is trouble in the markets. This has added to the speculation, recklessness, and almost universal belief that there are more "greater fools" to come.

In every cubic mile of sea water there is 25 tons of gold