Market Update – February 13th

I’m hoping to have a few entries this week (trying to keep them short).  Today, I want to discuss a short article that Warren Buffett wrote.  He seems to suggest that you should be investing in stocks and avoiding bonds.

Fortune published an abbreviated version of Warren Buffett’s upcoming letter to shareholders.  Here’s the link.  In it, he said that the dollar has fallen 86% since 1965.  During that period, a tax-exempt institution would have needed to earn 4.3% / year, just to maintain purchasing power.  If they were receiving 4.3% interest and thinking of it as “income”, they were kidding themselves.

During the same period, U.S. Treasuries returned 5.7% / year.  If you paid 25% in taxes, you ended up with no real return.  (You just ended up with your 4.3% to keep up with inflation.)

He suggested that bonds should come with a warning label.  They don’t come close to compensating investors for the risk of loss of purchasing power.

Buffett also railed on gold, arguing that it’s only worth what others believe that it will be worth in the future.  He said that there’s very little real use for gold.  He explained that all of the gold in the world could be melded together to form a cube 68 feet long on each side.  It would fit inside a baseball field and be worth $9.6 trillion!  (As a point of reference, the S&P 500 is currently worth $12.3 trillion.)

Instead of buying $9.6 trillion of gold (all the gold in the world), Buffett said that you could buy Portfolio B:

1. all of the U.S. cropland (400 million acres with output of $200 billion annually)

2. 16 ExxonMobils (the world’s most profitable company, earning $40 billion annually)

3. still have $1 trillion of cash

His point is that Portfolio B will compound and be worth more in the future than the cube of gold.  Buffett said that you need to invest in productive assets: businesses, farms or real estate.  You want investments that will retain their purchasing power while requiring minimal new capital investment.

A Few More Thoughts

1. In 2011, investors pulled $134.5 billion from U.S. equity-oriented mutual funds.  Since 2007, they’ve taken out $469 billion from U.S. stock funds.  During the same period (2007 – 2011), they’ve put almost $800 billion into taxable bond funds.

2. For investors who have missed the great return to Dow 12,800, it’s hard to put money in now.  This is the brutal part of market timing.  I believe a lot of people were able to successfully take their money out of the market in 2008.  The problem was figuring out when to re-enter.

3. Another way that a lot of people talk about stocks versus bonds is the dividend yield vs. the bond yield.  In other words, if the dividend yield (dividends divided by price) on the S&P 500 is 2% and the ten-year bond yield is 2%, many argue that stocks are much more attractive.  As long as stock prices don’t decline, the worst you can do is stay even.  (Of course, stock prices can decrease.) I’ve heard several analysts use this idea to support buying stocks at current levels.

4.  If you follow the “Fed model”, you would expect bond yields to be higher than dividend yields.  On average, you’d expect bond yields to be closer to the earnings yield (earnings divided by stock price).  If that’s the case, you are trading the risk of downside with stocks against the growth potential of stocks.  Of course, the Fed model doesn’t really work when bond yields are at 2% (it would imply a P/E ratio of 50).

5. Regardless of whether you compare bond yields to the dividend yield or the earnings yield, you realize that the Fed has tried to make stocks appear attractive by promising to keep rates low for a long period of time.  It’s one of the Fed’s goals – but there’s more to the Fed’s actions and I’m going to discuss this in the next week (after we discuss it in class).

6. Finally, some interesting math.  Google’s market cap is $197 billion.  Microsoft’s market cap is $256 billion.  Combined, their market cap is $453 billion.  Apple has a market cap of $460 billion.

Have a great week.

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