Very good article Joe, thanks.

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What are your thoughts on where interest rates will be in 10 years time? If the FED uses interest rates to combat inflation, it's reasonable to assume that if interest rates continue to climb over the next 10 years it's because inflation or inflation expectations are increasing.

I personally feel that the continued growth of the middle class in developing countries will result in increased productivity and technological gains, which should keep inflation in check. Especially as specialization and the division of labor increases in the developing world.

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Great report - thanks

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However, when Buffett made the above comment that stocks will most likely return 5-7% after dividends, the market was at a much higher valuation.

Assuming Buffett was correct, at a 5% return, the S&P should trade at $3,685 in 2019 (20 years after Buffett made that statement). If this still holds, the return over the next 11 years from current prices will be 12.7%.

Earlier this year, in the Berkshire annual report, Buffett talked about pension plans overstating their future return assumptions. By his calculations, they assumed equity growth of 9.2% after fees, which is too high. From 1900-2000 the Dow returned about 7.3% after dividends.

Buffett doesn't give an exact figure, but my guess is that he would say around a 6% return, after dividends and not including management fees. So, 10 years from the time Buffett wrote this (March 2008), the S&P should be worth $2,396. If this turns out to be the case, the annualized return from today's prices would be just under 10%.

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Hi Joe,

Excellent article.

Are interest rates and corporate profits two sides of the same coin ? Most businesses borrow money to grow. So, higher interest rates would imply lower profits and vice versa. I was a bit confused as to why they were presented as two independent variables.

Thanks.

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I was always a shrug-my-shoulders kind of guy. Now I get it. Like MaxO said, though, is that 6% from 8,800 or 6% from 14,000 or is it 6% from 80% of GNP? or...am I thinking too hard about it?

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I love Warren Buffett and of course, he's one of my guiding stars. Nevertheless, I'm still a "shrug-my-shoulders kind of guy, when it comes to this stuff. Yes, it's valuable information for those who were planing to invest in "the market" through mutual funds, etc. In my case, I reduced my contribution to my employee plan drastically months ago because it does not allow for individual stocks or even ETFs, so I deemed it a loser a while back.

The report is irrefutable, if you assume "business as usual" (now I see what you meant), but I don't believe in business as usual, specially not now. I believe several seismic changes are coming in green tech, infrastructure and health care. I also believe in the "division of labor" paradigm shift mentioned by BPal above as the global economy really gets into swing. Finally, as we all seem to agree on this site, what matters is buying great individual companies as cheaply as possible.

As to predicting future GNP, interest rates, overall corporate profits, etc. good luck with that. If the message of the report is that buying an index fund will not be nearly as rewarding over the next X years as it has been in the last X years, the message has a high probability of being correct. Me I'm gonna keep consulting Buffett while I look for my Fisher home run, my Motorola. Or to quote Field of Dreams, I'm gonna look for low and away, but watch out for in my ear.

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Interesting reading. I was at the Wesco annual meeting earlier this year, and Charlie Munger spent a good deal of time expounding on this very topic. As he put it, investors have been in "hog heaven" for the past 20 years and are in for some unpleasant surprises. He specifically counseled that the majority of investors would need tp "lower their expectations." He, too, put a figure of 5-7% returns as realistic.

I did not fully understand how Munger had arrived at this conclusion until reading this article. Now, the scales have fallen from my eyes, so thank you once again, Joe.

At the meeting, Munger also made a prediction as to what investors' psychology might be in the face of diminishing returns. He posited that investors would consciously or unconsciously assume greater risk chasing the kinds of yields that they had grown accustomed to. He predicted that this would be especially pernicious amongst pension fund managers and the like- people who's entire business is founded upon the belief that they will be able to earn annualized double-digit returns.

Further positing that these people would much rather fail as a group (i.e. make mistakes but have the "cover" of many others making the same mistake) rather that take a risk as individuals, Munger speculated that these vast pools of money would likely create quite a few more bubbles as they all pile into the same assets at the same time chasing that extra point or two of yield.

It should be an interesting decade or two.

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After my last post, I was wondering if I was being too polyannish. Then I watched this:


http://www.charlierose.co...

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Great article Joe. It was insightful and gave me a different perspective.

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Good report. The metric of the Wilshire 5000 as a percentage of GDP is a good one to look at, however, why did the chart stop in February? If you continue the chart out to present day you will see that the Wilshire 5000 is currently only 63% of GDP, very attractive.

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Great article Joe. I even went back and read Buffett's original article in Fortune magazine. One question I still have is why was the corporate profit as percentage of GNP lower during the times of higher GDP growth. Higher GDP growth usually means increases in revenues. What made the bottom line profit margins lower in the 1961 %u2010 1981. Was it capex spending, taxes? Or did productivity gains during 1981 %u2010 2008 produced greater margins on less GDP growth? I think in Buffett's article he hints towards capex spending and business re-investment.

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S&P 500 comps are often global players. More so as you look at the mega caps. This would lead to some nonlinear correlation between GDP and corporate profit for the S&P.

- Exchange rates
- US DP being different than the global rate.

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JC, It was expounded that huge growth in GDP can occur without the value of businesses rising, because even as a businesses SALE PRICS rise with rising GDP, a combination of pressures and factors; higher taxes, rising inflation, higher and rising interest rates, labour costs all leave the Returns to Capital Tiny. As a result the stock market goes nowhere for decades.
Ultimately I think with the broad market - its about productivity ;

A shareholder of a farm with 500 workers may get a small return from adding 1000 extra workers working a field as paying them all would leave only a small gain, dispite the 'farm economy' as a whole tripling in GDP, price to sales, and other measures of economic activity!

If the farm got a John Deere Tractor, which did the work of 1500 workers, and sacked most of its workers, the value increase of the business would be huge as productivity gains would be huge.

So the overall economy can bail out un-economic investments, add unproductive jobs, projects, etc... to 'mop up' the unemployed, without any real reference to productivity, and GDP can rise, economic activity can rise, but the value of businesses in the face of falling productivity, higher taxes, higher inflation, higher interest rates, stays static.

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All great comments!

I think we can all speculate as to why this would happen, and I think that some of you may have hit the nail on the head in part. I don't know why profits as a %age of GDP were rising or falling during these periods; but, I would suspect the answer requires a lot more space than we have here!

The big key to all of this is valuation. The markets will be higher if the value of the businesses are higher. I've said before that your discount rate doesn't matter, but that is only because we can't compare it to the long-term treasury right now. If government bonds began paying 20% interest, we'd have to increase our discount rate and desired return, which would ultimately lower the valuations.

Should we try to predict interest rates ten years from now? I don't think anyone can. All we can do is assume they'll be higher than today's unusually low rates, and use a higher discount rate. If, ten years from now, the 10-Year Treasury is paying 12%, we make our adjustments at that time.

From where we are today, we have a long way to 9% or so interest rates; so, you needn't worry about predicting the future of interest rates today.

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