According to Don Phillips of Morningstar, Warren Buffett proclaimed to his fellow shareholders at his Berkshire Hathaway shareholder meeting last May that "the average American today enjoys a higher standard of living than even the richest industrialist of a century ago in terms of our access to comfortable and speedy transportation, entertainment, and communications." Buffett's point was that our standard of living has never been better; yet, there are great opportunities ahead.
After fantastic market performance over the past five years and an extremely divisive election season, many investors are wondering if those glory days are truly in front of us. There was an article in the Wall Street Journal recently arguing whether or not the stock market was "pricey or not." The metric they used in the article is called the "cyclically adjusted price-earnings," or CAPE ratio. This ratio was the brainchild of Mr. Robert Shiller who happened to win the Nobel Prize - I have mentioned his name in previous quarter-end letters. If you will recall, he has mentioned that yes, his formula is stating that the stock market is expensive, but you cannot time the market based on his formula. In fact, his very own portfolio was balanced at around 50% stocks and 50% fixed income and he does not try to time the market as his formula would suggest you could do.
Anyway, many analysts have pointed to the CAPE and said that due to the high CAPE ratio (currently the CAPE ratio is at 27 - well above the 50-year market average of 20), the market is expensive and due for a decline. However, the Wall Street Journal reporter, Justin Lahart, points out that the denominator in his equation is GAAP earnings, which changes from time to time due to accounting rule changes. Thus, over the years corporations have had substantial changes in the definition of earnings and thus variations in the CAPE ratio. When you use a formula that has a more consistent definition of earnings, you end up with a CAPE ratio of 19, which is slightly above the 50-year average of around 17. While things are fully valued, I don't believe this is the time to adjust our allocations. Obviously, if your personal financial situation has changed, we would want to revisit your allocations. I thought this article gave credence to our diversified, buy-and-hold strategy.
Some of the items I will be watching for in the upcoming quarter include whether corporate earnings can keep up with expectations and whether or not the Federal Reserve will increase interest rates by a quarter point in December. Note that they are waiting until AFTER the election to increase the short-term borrowing rate. I am making a guess, but I would think our small-cap stocks and foreign stocks should continue to perform well into next year. Both of these areas seem less fully valued when compared to our domestic stock market.
As for all of you youngsters out there, continue to add to your retirement plans on a consistent basis whether the market is up or down. It is especially important to dollar-cost average into the stock market declines. Moreover, try to save at least 10-20% of your gross income for retirement (Vanguard recommends 12-15%, including any employer matches). If we end up with lower stock and bond market returns in the future, we need to make sure we are saving enough to accomplish our long-term retirement goals. While we may have market corrections here and there, it is important to have that long-term, positive focus that Warren Buffett has displayed over his many years of investing.