Is Buffett Correct That The Market Will Inevitably Rise?

by: Arizona Investor

The universal assumption that the market will keep rising is based on continuation of political stability and economic growth. This might not prove to be true during this century.

Individual investors have shorter timelines for needing return of capital. Luck will play a part in whether a given investment timeline is profitable.

Without a truly safe alternative, investing in stable and diversified groups of businesses such as Berkshire Hathaway seems a reasonable answer.

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497."

-Warren Buffett

Investors have many reasons for buying equities. Retirement savings, college savings, or just short term trading hoping to make some money are all common reasons retail investors are in the market. The investment timeline is therefore very different for everyone. I have read countless books and articles echoing Buffet's observation above. But will it continue to be true? And will it be true for all investors with varying timelines for investment?

Here's a thought experiment- suppose your great grandfather sold his farm in Iowa when he turned 65 and needed to invest the money so he and Gram could live. Would the stock market have been good place to put a big chunk? The answer, of course, is -it depends. If he was lucky enough to do so in 1920; and had the greater luck to sell in 1929 before the crash; he would have 600% returns- probably enough to keep him in a Model-T and speakeasy hooch for a long time. If he had to misfortune to put it in the market in 1929 before the crash- he would have lost 89% of his capital the next year; would be long dead before the market would have come back to break even point in the 1950s.

Of course there are many logical counterarguments- one of the most powerful is the concept of dollar cost averaging. If he had taken his farm money and steadily bought into the market by placing 20% in yearly from 1929 to 1933 he would have done pretty well by the 1940s with a 50% gain by the end of the war.

Since the Dow has had a seemingly inevitable and inexorable rise in the last century should we assume the 21st Century will yield the same results? This is where I disagree with much of the conventional wisdom. First - it is almost impossible to track "the market" from the first half of the 20th Century. Few of the Dow components are the same. There are the celebrated examples of formerly blue chip securities losing their luster: think Eastman Kodak as a famous example; and innumerable smaller companies going bankrupt or merging and becoming impossible to track and compare. Poor performers essentially were taken off the Dow and rising blue chips replaced them- overall market performance likely lagged the Dow by a considerable amount. For the sake of argument, let us accept the thesis that the market had an almost inevitable increasing trajectory in the 20th Century.

Let's pause for a trivia question: which country was generally considered to be the most advanced nation in the first half of the 20th Century? Scientifically, culturally, intellectually, musically, financially? Neither Britain nor the U.S! From a military standpoint- which country created nearly all advances in technology? Which country essentially created the modern submarine, tank, jet, rocket? By now you are realizing that Germany would have seemed an excellent place to put your money in the beginning of the last century. This would not have worked out well for you. Had you been a prosperous German citizen in 1905- the year Einstein wrote his famous papers while hoping for a German university job, you might have made a reasonable assumption to buy a diversified basket of stocks with an eventual good outcome. Wrong! Disastrous wars, hyperinflation after WWI- even if you survived the rise of the Nazis and WWII your investments would have been mostly shredded of value.

The last century was known as "The American Century" by many historians. This term was popularized by Henry Luce in 1941. Perhaps this is an overly simplistic way to characterize it- but it is hard to deny the influence and power the U.S. wielded. The U.S. had a clear financial superiority from WWII until the early 1970s; and then with financial resurgence from 1982-1999 the dollar has continued to be the de facto world's currency; accepted almost everywhere. Third world black markets and the trading of billions in oil contracts have the almighty dollar as the common element.

Without turning this into a political discussion- suffice it to say the United States has very massive challenges ahead. Threats such as unfunded liabilities, terrorism, middle class decline, foreign competition and others we are perhaps not seeing clearly in 2014 may unseat America as a hyperpower in the 21st century. I could point to many examples from Argentina to Zimbabwe of governmental mismanagement causing decades long economic decline. I hope this will not occur here but we, and our collective equity portfolios, are not immune.

So what is there to do about this? The first step is to admit to ourselves the inscrutability of the future. If growth in the index ends up much poorer than it has been, we will have to accept that most retirement accounts will be diminished. Achieving alpha and outpacing the index during a long term decline might then be more difficult.

The second step is to effectively manage risk tolerance and accept that there is no truly safe option. Cash, real estate, bonds, precious metals used to diversify portfolios all are problematic during the timeline toward retirement.

- Holding cash inevitably leads to inflationary loss. How the Consumer Price Index is calculated and whether excluding food/energy costs yields a valid result is controversial. There is near unanimous agreement that many prices will be higher years from now and this will affect retirements of many. The recent drop in oil prices and the threat of worldwide deflation led by commodity price drops is unlikely to be permanent. Billions of people not now using fossil fuels or electricity would like to.

- Real estate prices have proven not to rise indefinitely and have substantial carrying costs. Investing in real estate in 2006 had a terrible outcome for many. Commercial real estate in particular might suffer a long term, decades long loss if internet commerce continues to steal from brick and mortar stores. If we exclude the highest end trophy properties then most of the residential real estate market is influenced by interest rates and a significant increase in rates may diminish long term prices.

- Bonds feel reassuring but are paying very low rates currently- only the "high yield" bonds are paying a decent rate but likely not enough to make up for their risk. Buying bonds during historically low interest rates may also cause significant capital loss if and when rates begin increasing.

- Precious metals have been used as an inflationary hedge but they too can suffer very long declines. Gold was up to $850/oz in 1980; had a 20 year decline of more than 50%. This does not mean that precious metals or commodities cannot have a place in portfolios- just should not be counted on as a reliable investment over a given time period for retirement.

So despite the fear, uncertainty, and doubt we should have about growth during any given timespan- I cannot come up with a better investment plan than putting most of my investment capital in a variety of companies and hoping that they survive and thrive during the time I hold them. For instant diversification and avoidance of dividend taxation I own a big chunk of Berkshire in my taxable account. Whether the market will outpace inflation over my timeline of roughly 25 more years is out of my hands but by no means assured. And so I hope that Buffett's words will prove correct although I have my doubts. Good luck to all!

Disclosure: The author is long BRK.B. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.