Buffett’s Rules And Ratios

In a CNBC interview on Monday, Warren Buffett, the Oracle of Omaha, declared that stocks are “on the cheap side.” He has played the Trump rally by putting another $20 billion into the stock market since Election Day. Stocks are cheap, he said, because interest rates remain very low. This suggests that Buffett is betting both on and against Trump. He obviously made a very good decision not to let his personal politics get in the way of joining the animal spirits rally since Election Day. Warren Buffett is a long-time Democrat who supported Hillary Clinton, but he says he agrees with President Donald Trump on some issues—including homeland security as a top priority, boosting economic growth, and increasing the incomes of more Americans who have been hurt by globalization.

Yet, Buffett seems to be betting that interest rates won’t go up much anytime soon. In other words, he isn’t convinced that Trump will succeed in stimulating the economy very much with fiscal policy. He said that Republican leaders will probably have to scale back their tax reform ambitions because their current plan is too complicated to pass Congress, especially if they intend to do something on this by August: “I think complexity will give way to speed.” He expressed skepticism that the Republican tax plan will be revenue-neutral “without the craziest dynamic scoring in the world.” He also said that he doubts that the border adjustment tax (BAT) will see the light of day.

I agree with Buffett on the revenue-neutrality issue. The plan that the administration is outlining suggests a guns-and-butter fiscal approach with more defense spending, no cuts in entitlements, and lower tax rates. It’s hard to see how this won’t lead to higher bond yields, especially if the Fed starts increasing the federal funds rate at a pace closer to normal. (I am still forecasting that the US Treasury 10-year bond yield will range between 2.00%-2.50% during the first half of this year and 2.50%-3.00% during the second half of this year.)

In his interview, Buffett told CNBC on Monday that mixing politics and investment strategies would be a “big mistake.” He added, “Probably half the time [in] my adult life, I’ve had a president other than the one I voted for, but that’s never taken me out of stocks.” That’s been my pitch for a while: Investors should focus on whether the political environment is on balance bullish or bearish, not on whether the policies are right or wrong.

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The Oracle of Omaha is credited with having devised the Buffett Ratio to measure stock market valuation. This indicator takes the market capitalization of all stocks traded in the US and divides it by GDP. In an interview he did with Fortune in December 2001, Buffett said, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.”

Yet, Buffett thinks that stocks are cheap even though his ratio has risen from a cyclical low of 1.51 during Q3-2015 to 1.59 during Q3-2016. So it is approaching the cyclical high of 1.69 during Q1-2015 and the record high of 1.80 during Q1-2000. That’s using the Fed’s quarterly data on the total market capitalization of US equities excluding foreign issues. Now consider the following related indicators:

(1) S&P 500 Buffett Ratio. A similar ratio using the market cap of the S&P 500 to the revenues of this composite is highly correlated with the Buffett Ratio. It was 1.82 during Q4-2016, nearing the record high of 2.01 during Q4-1999.

(2) Forward ratios. It turns out that the S&P 500 version of the Buffett Ratio is highly correlated with the S&P 500’s price-to-sales (P/S) ratio using forward revenues as the denominator. On a monthly basis, it rose to 1.91 during February, suggesting that the Buffett Ratio is already back to its previous record high, just before the tech bubble burst.

I also monitor the forward P/S ratio on a weekly basis. It rose to a record high of 1.91 during the week of February 16. It is highly correlated with the S&P 500’s forward P/E, which rose to 17.8 during the same week.

There are two alternative economic scenarios that follow from the above discussion. The economy continues to grow in both, though running hotter in one than the other. Of course, there is a third scenario in which the economy falls into a recession. That’s possible if Trump’s protectionist leanings trump his pro-growth agenda. However, I believe that Trump is intent on maintaining free trade, but on a more bilateral basis than a multilateral basis. So here are the two growth scenarios in brief:

Very hot. If Trump delivers a guns-and-butter fiscal program—including most of the tax cuts he has promised along with more defense spending and public/private-financed infrastructure spending—economic growth could accelerate. But so might inflation, given that the economy is at full employment. Government deficits would probably remain large or widen, causing public debt to increase. In this scenario, the Fed would be emboldened to increase interest rates in a more normal fashion rather than gradually. Bond yields would rise. This should be a bullish scenario, on balance, if the boost to earnings from lower corporate tax rates and regulatory costs is as big as promised.

Not so hot. Alternatively, if Buffett is right, and interest rates stay at current low levels, that would imply that Trump’s grand plans for the economy won’t be so grand after all in their implementation. Animal spirits would evaporate. Interest rates would stay low, but valuations would be hard to justify if earnings don’t get the boost that was widely discounted after Election Day.

I am rooting for animal spirits.