Buffett Metric Doesn't Say It's Time to Buy

There is a chart and a story going around regarding Berkshire's (BRK.A) Warren Buffett that just does not jive to me. First, here is the chart:

Click to enlarge

Here is the story that follows:

(Fortune Magazine) -- Is it time to buy U.S. stocks?

According to both this 85-year chart and famed investor Warren Buffett, it just might be. The point of the chart is that there should be a rational relationship between the total market value of U.S. stocks and the output of the U.S. economy - its GNP.

Fortune first ran a version of this chart in late 2001 (see "Warren Buffett on the stock market"). Stocks had by that time retreated sharply from the manic levels of the Internet bubble. But they were still very high, with stock values at 133% of GNP. That level certainly did not suggest to Buffett that it was time to buy stocks.

But he visualized a moment when purchases might make sense, saying, "If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you."

Well, that's where stocks were in late January, when the ratio was 75%. Nothing about that reversion to sanity surprises Buffett, who told Fortune that the shift in the ratio reminds him of investor Ben Graham's statement about the stock market: "In the short run it's a voting machine, but in the long run it's a weighing machine."

Not just liking the chart's message in theory, Buffett also put himself on record in an Oct. 17 New York Times op-ed piece, saying that he was personally buying U.S. stocks after a long period of owning nothing (outside of Berkshire Hathaway (BRK.B) stock) but U.S. government bonds.

He said that if prices kept falling, he expected to soon have 100% of his net worth in U.S. equities. Prices did keep falling - the Dow Jones industrials have dropped by about 10% since Oct. 17 - so presumably Buffett kept buying. Alas for all curious investors, he isn't saying what he bought.

To examine this we need to go back the beginning.

One must remember that in the late 1960 Buffett closed the "Buffett Partnership" because at that time he felt "there were no values" in the general stock market. Yet, according to both the chart above and the story, Buffett would have been buying at this time.

If we fast forward to the mid 1970s, a time when Buffett said he felt like "a guy in a whorehouse with a suitcase of cash" because stocks were so cheap, we see the above chart's value level was actually below 50%. In fact, most of the largest positions in Berkshire's portfolio, American Express (AXP), Coke (K), Gillette now PG (PG) and The Washington Post (WPO) were accumulated during this time. In fact, Buffett's buying continued through the 1980s and until the mid 1990s when he found equity values were overpriced, refrained from buying during the tech bubble and was called "out of touch" (he was later proven very right).

Again, looking at the chart, we see during this time frame the chart values had crept back to the 75% level of the mid 1960s when Buffett was a seller.

What is important to note and what has been lost in the "Buffett is buying rhetoric" is that Warren's three largest recent investments, totaling roughly $10 billion, Dow Chemical (DOW), GE (GE) and Goldman Sachs (GS) were NOT stock purchases, they were preferred investments.

Essentially Buffett is betting their share prices will all rise, in the next 3 to 5 years, when the convertibles convert to common stock. Until then, he has a bond paying 10%. With Treasuries paying essentially nothing, Buffett has found a vehicle that pays 10% to park his cash.

Did Buffett pen the link article above? Yes. To be sure Warren is buying an interest in U.S. companies as witnessed above, just not their common stocks (except Burlington Northern (BNI)).

Buffett's preferred purchases are not an endorsement of cheap U.S. equities. If anything, it says he would rather be a bondholder than an equity one... for now.


Disclosure: Long Dow, GE

Comments

[JBD:]

Rather than engage in idle speculation, I prefer to read the words of the man himself-- www.nytimes.com/2008/1...--- "Buy American, I am." It is probably time to be selectively greedy with all this fear running amuck on Wall Street and Main Street. The more doom and gloom the better for long-term buyers.

Feb 10 01:27 PM

[Jolly_Rancher:]

Very incisive article. A similar article appeared recently on Seekingalpha except that author was asserting that 75% is where Buffett is a buyer, and I wrote a response somewhat similar to yours. It makes no sense for Buffett to be a buyer at 75% because that level is still too high according to his standards. 50% - 60% is his range.

The problem with all of this analysis is that we're talking about apples and oranges, i.e. overall market vs. value investing. Buffett will invest in a particular business if he finds the value regardless of the Market-to-GNP number. My guess is that he has found more than a few businesses whose stocks have been decimated and which he would consider to be values. But would he buy the SPY here? Most definitely NOT because it's still too expensive.

BTW, Buffett purchased those preferred shares through Berkshire Hathaway, not his own personal account. No one knows the changes in his personal account.

Feb 10 01:27 PM

[Smartinvest...:]

When did Buffett's metric show to sell???? I guess I missed it, as did he.

Feb 10 02:19 PM

[DonSuper:]

hey! you are the genious that was recommending to buy dow chemical at around $40 right?

your (pseudo) analysis lacks a key variable, interest rates, as well as the inflation rate, which are critical to value any financial asset...

also, he has bought more shares than just BNI, he has recently bought significant stakes in COP, and USB. And not too long ago he made the JNJ and KFT purchases at higher prices than today.

Feb 10 02:20 PM

[Carl Spackler:]

I am extremely tired of hearing that the market is a buy or sell because of what Warren Buffet is doing. He was wrong on this market and the economy, and I suspect he is extremely perplexed by his losses right now. Many of the deals that have propelled his stock were caused by the sheer weight and power that billions of dollars give you. He gets extremely good returns from hurting companies because he can throw them a lifeline of billions. Can an individual do that - no! He gets huge positions of convertible stock with high dividends - can an individual demand that - no! When he buys 4%+ stakes in companies, he can demand changes and they listen - can we do that?

What he does is by no means very applicable to you and I. If you are looking for an investment model for someone with $10 billion in the bank, he's your man. He has done a wonderful job in that regard, but if you are running your own $1mil portfolio you need to find a more comparable role model. Warren Buffet (and his investment methods) have as much in common with us as a tree frog has in common with a bird.

Feb 10 03:32 PM

[Stock Marke...:]

Swiss Re, Harley Davidson, Goldman Sachs...all getting double digit yields while he waits for a turnaround..whenever that happens...

Feb 10 07:06 PM

[User 689427:]

Buffett got his position in Gillette from buying $600 million in convertible preferred stock around 1989 which later became stock.

This article incorrectly states he acquired the position in the mid-70's.

Feb 10 08:40 PM

[User 261697:]

Great article, makes me wonder if now is the time to buy. Although, I still don't understand where Buffett gets the 70-80% range?

Feb 10 10:02 PM

[Karl Glazier:]

In recent years an increasing amount of earnings of U.S. stocks have come from international sources.
That, and today's record low interest rates means today's 75% is probably comparable to 1975's 50%.

Feb 11 12:45 AM

[antiquary:]

"Buffett's preferred purchases are not an endorsement of cheap U.S. equities. If anything, it says he would rather be a bondholder than an equity one... for now."

Bad analysis, because he got the rates he did because of the same general level of investor sentiment which the inexpensiveness of U.S. equities is merely another reflection of, and because in this environment the risk is the same either way. We just call it default on a bond rather than bankruptcy, and you haven't made the case that this distinction in looking at Buffett's investment should be important to the rest of us.

Feb 11 11:41 AM

[MKJ:]

Buffett writes in the original article that the market/GNP metric doesn't tell you everything you need to know, but it is a good general guage of when you should/shouldn't be interested. He also talks about the importance of interest rates.

The ten year was at 8% at the end of 1969 vs. under 3% now. More importantly, the p/e based on an average of the past ten years of earnings was 15.9 (5% earnings yield) at the end of 1969 vs. about 15 now (about 6.5% earnings yield). So, in 1969 you could do better buying the ten year than stocks. This is not the case now. In fact, the spread between the ten year average earnings yield and the ten year is greater than it was in the 70s.

Feb 11 08:21 PM

[kalasend:]

How about saying that Warren Buffet will be buying when equities are either outrageously low-priced OR when his country's fortune is on the verge of total collapse?

Or, take this, you're in whorehouse with a suitcase of cash....except that the building is on fire, doors are locked and you know the chicks there ain't capable of putting it out. In both cases you'd be a consumer anyways....

Feb 12 01:07 AM

[Jim Hawthorne:]

Nice article, Todd! As usual, you dig beneath the shrill headlines and the 30 second sound bites!

Despite the reams of articles supposedly describing either the 'Buffett-style of investing' or reporting on what he has or has not done, many still fail to understand or appreciate the simple, patient elegance of his investing methodology.

This investment methodology is based on fundamental valuation (including management competence), LOB/product/service prospectus, and long-term viability.

Buffett does not so much time the overall market as time the 'reversion to the mean' of the individual equities on his radar screen, snapping them up when they fall well below projected valuations.

While we can indeed chart Buffett's moves and see how he moves into positions after deviations from the mean, he has never lost sight of the simple fact that charts are driven by price action through time; Price is not driven by trendlines on a chart!

Feb 13 08:32 AM

[GregR:]

I realize the metric is meant to be nothing more than a rough guesstimate of how relatively expensive equities are. But that said...

1) only the market capitalization of publicly traded companies is being measured against GNP. Over the last 85 years, I wonder how much variability there has been in the relative GNP contribution of non-publicly traded companies, the government sector, etc.

2) all stock holdings by one company of another essentially get double counted in the market capitalization number even though this creates no effect on GNP...

Feb 13 11:44 AM

[Dan O'Neill:]

Your article needs a fact check. First of all, Gillette and Coke were bought in the late 1980s. If you are going to quote Buffett, then get it right. He said when he was asked about how he felt about the market [in 1974] "Like an oversexed man in a harem". You should go back to college and learn how to write effectively and not to make things up.

Feb 15 09:45 PM