About two weeks ago Warren Buffett published his annual letter to Berkshire Hathaway investors. As usual, he covered a raft of subjects, and a main focus in the media was the tweaking of his portfolio.
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But I thought some of his comments in individual interviews were even more interesting, such as his increased stake in Apple and his complaints about the fees investment managers charge.
In one interview, for example, he said he didn’t understand why someone would buy 30-year government bonds at a nominal yield of 3 percent. Why commit money for 30 years at a return that barely beats current inflation?
He was right, of course; such bonds seem like a very poor investment. Ostensibly there isn’t a single logical reason to buy them, but the market doesn’t work that way.
But actually, the person who buys those bonds is a rational being making the right decision from his point of view. How? The vast majority of those bonds are held by institutional investors that are managing pension funds and whose managers are assessed each year. They’re obligated to hold a certain percentage of government bonds and highly rated bonds.
If these managers hold bonds for short periods in order to avoid the long-term commitment mentioned by Buffett, as long as there’s no dramatic change in the government bond market, they’ll underperform their colleagues.
Another reasonable possibility from their point of view is to hold long-term bonds too, for a little more current return. That’s also true of real estate, for which the return at present is low, and of course of stocks, which are traded at high multiples. This is a well-documented phenomenon: The person managing the money is influenced by the investment risk or the risk to his career for a period of one or two years. It’s less important to him to make rational decisions based on a projection five or more years into the future.
It’s hard to blame people like this; they’re working in impossible conditions. A zero or even a negative interest rate is precisely the environment that creates this conflict. It’s caused by a heavy distortion of prices for the long term versus competition for short-term results.
Buffett can criticize such investors; because of his age, status and history, he doesn’t have to worry. If he were a 40-year-old money manager for an investment company battling the competition, there’s a good chance he’d have a different opinion.
Another thing that caught my eye among the many interviews and articles was a mention of Buffett’s amazingly accurate forecast almost 18 years ago. Speaking to Fortune Magazine in the summer of 1999, the Oracle of Omaha deviated from his custom of not predicting the stock market.
He of course didn’t answer the absurd question one often hears in the media: “Where will the market be a year from now?” Instead, he said investors in the next 17 years (in other words, until 2016) had no reason to expect the returns they saw between 1982 and 1999.
Berkshire got hit too
The choice of 1982 as the basis was no coincidence. That was the year a long-term bull market began after years of low returns. Buffett estimated that the S&P 500 Index would return about 6 percent annually about 3 percent in dividends and 3 percent in stock rises based on growing profits.
Sure enough, this 3 percent plus 3 percent annual-return forecast turned out exactly on the mark.
Investors of course expected a lot more, and it’s not hard to understand why. During the 17-year bull market, the average annual return was 15 percent before dividends, a pace in which the index doubles every five years. So 6 percent a year including dividends seems a bit pathetic. The 20-year long-term government bond yield was 6 percent.
Who thought that over the next 17 years stocks and bonds would provide the same return? Regarding stocks, the skies looked relatively clear.
Only one thing disturbed the idyll. Stock prices were high relative to companies’ profits. For a period of one or two years, high stock prices are of no great significance for market behavior. Expensive stocks can become even more expensive. But over a period of many years, the high prices are the main factor.
Let’s go back to today. Buffett discusses the minimal importance he attributes to market collapses. They’ll happen occasionally, and it will always seem a surprise. Nor is he upset by a decline of 40 percent to 50 percent in Berkshire shares. For example, in the 50 years he has been managing his firm, he has experienced three periods in which the stock declined by more than 40 percent from a peak.
The facts speak for themselves. From the 1960s until now Berkshire’s stock has fallen big-time three times. Unsurprisingly, the overall market suffered a similar decline. The first time was in the 1974 bear market after the first oil crisis and after several years of a rising market. Two years of a bear market erased five years of returns.
The other two instances came between 2000 and 2002 and from 2008 to 2009. Not only did the frequency of the crises increase, so did the intensity. By 2002, Berkshire shares had regressed five years, just as in 1974. But by 2009 they had regressed 10 years – something that hadn’t happened since the ‘30s, the terrible years of the Great Depression.
Buffett's two advantages
Buffett’s ability to withstand crises is well known. More than once he has emerged from a crisis in better shape simply because he was able to buy at record-low prices. True, he had reams of cash, but no less important, he had emotional fortitude. We have to admit that many investors and investment firms lack those two traits.
They tend to be caught in collapses with little cash and lacking Buffett’s patience. So telling them to keep a stiff upper lip may be good advice, but it’s irrelevant. It’s just like saying that a 30-year bond is a bad investment today. Most investors and investment managers simply differ from Buffett regarding their nature and the constraints they face. He’s in a unique position.
Is there any significance to the fact that the length of time between crises has shortened? Is it a coincidence – a random statistical deviation – that in the 30 years between the ‘60s and ‘90s we only saw one significant crisis, while in the past 20 years we’ve seen two? Or does it reflect a change in the financial markets?
My feeling is that the change isn’t a coincidence but rather a phenomenon – a structural change in the markets that will remain in the coming years. Of course I have no scientific way to prove it; the historical sample is too small and the number of external factors having an influence is huge. As I said, it’s only a feeling.
As the years pass, the financial markets seem more violent – both the highs and the lows. That could be explained by a different macroeconomic and monetary policies that support the markets during times of decline to the point of inflating bubbles that burst later on.
Maybe it stems from the greater participation of millions of small players who make sudden moves on a quick whim. Maybe it’s the heightened media interest that amplifies the natural feelings of fear and greed.
In any case, I think that the high and low tides have become stronger. As someone who loves the sea, maybe there’s a physical phenomenon here similar to that of waves. The larger the body of water, the greater the strength of the waves that can develop.
So even if we created winds in Lake Kinneret like those in the Mediterranean, the waves would never reach the intensity of those in the sea. And if we created conditions in the Mediterranean similar to those in the ocean, we would discover something similar. The waves would be high, but not like those in the ocean.
It’s possible that because the number of participants and the amount money in the financial markets have increased much faster than the real economy, they produce higher waves just like in those larger bodies of water.
Of course, that’s only a theory, so I can’t prove or disprove it. Still, if it’s right, investors have to be aware of it. Not everyone is Warren Buffett, and not everyone has such a strong stomach.
Most of us don’t. There could be years in which the financial markets produce low returns, as derived from the high stock prices relative to companies’ profits. All the while, there will be waves of strong increases and plenty of crises, as has been the case over the past 20 years. That doesn’t make for smooth sailing.
Doron Tsur is an independent financial consultant. This article should not be seen as a recommendation of any type of bond; the writer is likely to have a position regarding bond types mentioned in this article.