Buffett delivers his usual mix of aw-shucks humor ("I've reluctantly discarded the notion of my continuing to manage the portfolio after my death--abandoning my hope to give new meaning to the term 'thinking outside the box.'") and searing insight ("During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher 'earnings.'").
On page 19, Buffett asks whether pension plans' explicit assumptions of 8% annual returns are plausible:
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets--which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments--must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.
How realistic is this expectation? Let's revisit some data I mentioned two years ago: During the 20th century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow--recently below 13,000--would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.
It's amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
All of which reminds us of a recent Vitaliy Katsenelson piece in Financial Planning and an August, 2004, story in the FT titled "Buy-and-hold on permanent hold," both of which make what seems to us a relatively straightforward point: After the raging bull of 1982 to 2000, equities are likely to remain relatively range-bound for a substantial period. From the FT's Elizabeth Wine:
US stock markets have been on a roller-coaster ride since the late 1990s. After all the sound and fury, the markets have been flat since summer 1998. The advice from strategists? Get used to it.
Long-time market participants ranging from Peter Bernstein to Ralph Wanger believe the US stock market is in the midst of a long-term trading range reminiscent of the middling market of 1966 to 1982. If true, it has big implications for the notion that buy and hold is the best and only solution for long-term US investors.
And from Katsenelson:
[O]ver the past 200 years, every full-blown, long-lasting bull market-we just had a supersize one from 1982 to 2000-was followed by a range-bound market that lasted roughly 15 years. (The current range-bound market may last longer because it started at very high valuations.) This happened every time over the last two centuries, with the exception of the Great Depression.
Why? Contrary to common perception, inflation, gross domestic product or earnings growth-although responsible for short-term market volatility-have not driven long-term stock market cycles. The long-term driver has, in fact, been the compression of high market valuations. Dividends aside, returns from stocks can be mathematically explained by two variables: earnings growth and price-to-earnings expansion. During bull markets, a vibrant combination of P/E expansion and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets end with P/Es much above average-the year 2000 market ended with the highest valuations we had observed in the 20th century. P/Es, however, are mean-reverting creatures, and after a bull market, high P/Es will head down toward and below the average. This P/E compression wipes out most, if not all, earnings growth, resulting in meager returns.
All of this has enormous implications for the management of corporate, pension, and personal assets. For people in the accumulation phase of their investing lives, this notion should be entirely welcome. For those in the preservation or distribution phases, on the other hand, it raises serious and very difficult questions about the meaning of risk and the utility of various money management strategies and products.
We'll be revisiting this important topic in the weeks and months to come.
Warren Buffett, "Letter to Shareholders of Berkshire Hathaway Inc.," (.pdf) February 29, 2009
Elizabeth Wine, "Buy-and-hold on permanent hold," Financial Times, August 30, 2004
Vitaliy Katsenelson, "In Bounds," Financial Planning, March 1, 2008