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Jim,

I was hoping if you could share your views on the market as we see it now. I know no one has the crystal ball, but you are one who I feel is the closest to it ):

While it is relatively easy (nah, darn hard) to ignore the wall street noise, it seems very confusing to decide the path from here, and the bulls and bears are all over the place.

In your view, which do you think is more likely:

A) Market (S&P 500/ BRK/ QQQE etc.) goes up by 10% or more in 1 year
B) Market goes down by 10% or more
C) Recession and Lots of volatility but overall neutral market by 1 year
D) Deep recession and Huge collapse like 2000/ 2008
E) Dare I say, remarkable bull run > 20%

Thanks for indulging ):

Peter

Julian, if I may use the opportunity: The (only) one thing missing are the old board's polls.

Jim,
I have also used your 10/1/2022 Nostradamus prediction as my North Star(I found it 12 days after you posted). For those that haven't read it, enjoy. https://mungofitch.com/

In the almost 9 months since you wrote it the S&P500 is up about 21%. Has it over shot?

And does it really matter, if you're building a diversified portfolio of businesses at a good value?

Frankly, I look at MY portfolio now and believe I have the most diversified and undervalued businesses I've ever owned and I think I'm poised for some really big gains over the next year or two or three.

In that vein I figure something external is going to F this up.

Please elucidate!

With affection and admiration,
Chris

It's somewhere between touching and scary that anyone thinks I know what might happen next : )
I have no crystal ball. The future will be what it will be.

That being said, as always I'm never at a loss for an opinion.
Never let the lack of facts stop you!

I do think an upcoming US recession seems all but assured.
If I had to guess, I would imagine the official kickoff will end up being called for winter, sometime maybe November-April.
But a recession is very different from a bear market, so even if that's correct it's no help for investments.

If you're one who cares about the level of the broad US market, I wouldn't lose sleep just yet.
It is extremely rare to see a market drop that is both big and lasting so soon after fresh recent highs.
And market breadth has been quite good lately.
So it's probably safe to play in the water for the next little while, with or without swimming trunks.
(a plunge is always possible, but when it's soon after fresh highs it tends not to last long).
Usually market tops are squiggly but beyond the short term squiggles they mostly roll over pretty slowly.

However, that happy prognosis is pretty short term. What will happen 3-12 months from now, I have no idea.
My rule of thumb: the longer it has been since a fresh recent high, the lower the expected AVERAGE rate of return in the next month.
Risk rises gradually, because exuberance fades gradually.

There have been many chipper pronouncements from investment banks about the real estate problems having fizzled out already--"the worst is behind us".
I'm not buying it. I think the rumbling effects of the rise in interest rates will continue for a very long time, and more localized explosions would not be unanticipated.
Falling real estate prices, though probably pretty slowly.
A whole lot of people built business plans on the assumption of free capital, and they will need new plans. Not to mention new capital which won't be forthcoming.

I think Berkshire will continue to make money, and grow in value on trend. Valuation isn't stretch, at most just a hair above post-crunch multiples.
We had a couple/few above average years, and now we'll have a couple of below average years, but the long run real trend remains remarkably intact.
Still, things could be a bit better.
If there is anything disappointing to me, it's the recent operating earnings.
There is the optimistic expectation that good business units have pricing power and can plow through bouts of inflation by pushing through price increases.
If that isn't true, it's a problem.
Offsetting that is the merely cyclical problem that business is getting a little bit tough in many areas, so a bit of a cyclically slowdown wouldn't be a worry.
I'm a little on the fence trying to allocate my observations between those two interpretations.
I keep track of what I call the "steady things": after tax income on rails, utilities, manufacturing/service/retail, and a proxy number for cyclically adjusted underwriting profit.
I then apply a seasonal adjustment, and set the absolute value based on the last year or two of results. This is all done after inflation adjustment.
This is usually a pretty good predictor, since (as mentioned) this is just the "steady things".
But the predictions have been consistently low for the last four quarters. Earnings are emphatically NOT keeping up with inflation.
These are the recent figures, in end-March dollars:
Expected $4754m, actual $4126m, lower than expected by -$628m
Expected $5382m, actual $4553m, lower than expected by -$829m
Expected $4473m, actual $3988m, lower than expected by -$485m
Expected $4387m, actual $3944m, lower than expected by -$443m
Total shortfall $2.195 billion in after-tax earnings in a year.
Each quarter is scaled based (mainly) on the prior four quarters, so a rescaling blip should disappear quickly. But it isn't.
So...I think Berkshire will do fine, and it's still my biggest investment by a vast margin, but the short term progress in observable value isn't great just lately.

Anecdotally, individual stocks seem to have a wide dispersion of valuation levels.
Some things seem implausibly cheap, some things seem implausibly expensive.
I try to keep my portfolio concentrated a little more on the former, but of course reality often disagrees with me about what the prospects of a firm might be.
Mostly I don't play the index any more, even for hedging. Oddly, many individual firms seem far more predictable.

Jim

Brilliant, as usual! Thanks Jim.

Jim once again THANK YOU for being so generous and sharing your thoughts.
Your post are very helpful for teaching me what to look at and to keep learning about investing.


I would appreciate if you can share a little bit about what are the companies that you see implausibly cheap.

I would appreciate if you can share a little bit about what are the companies that you see implausibly cheap.

It's not a simple question. Certainly a dangerous one to answer.

Firms that are ostensibly cheap are generally that way for a reason. Sometimes a good reason, sometimes not.
So to believe that such a firm is *truly* cheap requires disagreeing with the market consensus of the relative importance of the obvious flaws.
You don't want to disagree without knowing something about the firm, so you can form your own opinion about whether the problem is a big one or not.

An example would be Bread Financial, BFH.
The stock price is barely a tenth of what it was five years ago.
They're expected to make in the vicinity of $10 a share this year and next, but the stock price is under $30.
So clearly the market thinks they are in real trouble, and those earnings will not last.
Plus, of course, they're expected to make a little less money next year than they will have done this year. A shrinking trajectory is never popular.
I have followed and owned the firm for quite a while, and it certainly hasn't done me any good.
But it is perhaps worth reading about them and forming your own opinion.

Another example might be Tupperware, TUP.
They are expected to make $0.83 next year, compared to a current price of $0.75.
Despite being in the "seemingly cheap" category, this one I won't touch.
I remember Mr Buffett saying, when asked about the future of newspapers: ask yourself, if they didn't exist, would somebody have to invent them?

Other firms seem cheap to me because they are not obviously cheap on current business results, but I believe their growth trajectory to be sufficiently assured that they seem quite cheap relative to conservatively estimated future prospects.
When looking for serious value I like firms trading at under 10 times my estimate of the "pretty darned sure" average real EPS 5-10 years from now, preferably even less.
For example, I think Dollar General (DG) can manage a bit more than the ~5.5%/year real EPS growth that would require.
The future does not necessarily resemble the past, but EPS grew about nominal 19.5%/year in the last five years. Unusually good years, but still, not bad.
They know how to make a buck.

My comment was more of a macro one: there are many firms that are ostensibly cheap, perhaps more than usual.
On average there are around 150-160 stocks in the Value Line 1700 trading at under 10 times their estimate of current earnings.
At the moment it's closer to 300.
Which of those might actually be good investments at this juncture is a very different question.

Jim

Mungofitch wrote:"A whole lot of people built business plans on the assumption of free capital, and they will need new plans. Not to mention new capital which won't be forthcoming."

On a similar note...

June 2023

End of an Era: The Coming Long-Run Slowdown in Corporate Profit Growth and Stock Returns

"I show that the decline in interest rates and corporate tax rates over the past three decades accounts for the majority of the period's exceptional stock market performance. Lower interest expenses and corporate tax rates mechanically explain over 40 percent of the real growth in corporate profits from 1989 to 2019. In addition, the decline in risk-free rates alone accounts for all of the expansion in price-to-earnings multiples. I argue, however, that the boost to profits and valuations from ever-declining interest and corporate tax rates is unlikely to continue, indicating significantly lower profit growth and stock returns in the future."

https://www.federalreserve.gov/econres/feds/end-of...

Talking about banks, here is another good bank to consider: industrial and commercial bank of China. It's very safe simply because it's the largest national bank, it would collapse only if China collapse, dividend yield of 8.37% and increasing every year at about 5%, PE about 3.9.
https://finance.yahoo.com/quote/IDCBY?p=IDCBY

Very cool link, thanks.
And it carries much more weight coming from a Fed economist than coming from "some guy" on Seeking Alpha

For anybody wondering why net profit margins have soared, Figure 1 really sums it up nicely.
Interest + tax was around 55% of EBIT around 1972-1992, and has since then steadily fallen to about 25% of EBIT, a fairly steady decline.

This process has taken so long that a lot of observers seem to think that the rate of real profit growth since then is normal and natural and can be safely extrapolated.
But, assuming this process has a natural end, aggregate profits can't grow any faster than sales.
And if the process reverses at all, aggregate profits will grow more more slowly than sales for a while.

FWIW, real total sales from US non-financial corporations rose 1.72%/year from 2005 to 2022.
FWIW, real total sales from US non-financial corporations rose 2.25%/year from 2015 to 2022.
The baseline years were chosen to be neither peaks nor troughs.
Sales data from here https://fred.stlouisfed.org/series/BOGZ1FA10603000...

Using those figures as a rough guide, at constant net margins aggregate profits "ought" to rise at around inflation + 2%, give or take a bit.
Absent changes in valuation multiples, the real total return to expect from a broad slate of US companies should be that, plus the dividend yield.
Of course there will be changes in valuation levels, but that's hard to predict. We can probably rule out forever increasing multiples.
The SPY dividend yield is about 1.55% at the moment.

From my database, most of whose fields come from Dow Jones News:
A trend line through real S&P 500 earnings since 2000 has risen at a rate of 2.800%/year since January 2000.
A trend line through real S&P 500 dividends since 2000 has risen at a rate of 3.000%/year since January 2000.
The notion is that one should not take this rate of increase as normal--both should be expected to slow down to the rate of real sales growth.
S&P 500 real sales per index point have risen at a rate of inflation + 1.85%/year 2000-2022 inclusive, using data from multpl.com. (again, slope of a trend line fit, not end-to-end rate)

Jim

I agree, thanks for sharing the article - it was a very good read. And very sobering.

Is the data that could be used to apply a similar analysis to Berkshire available?

It'd be interesting to see how much of recent years' BRK performance could be attributable to low interest rates and corporate tax rates that might never return.

And what that analysis would predict for Berkshire's future performance (all else equal), for comparison to the +2%/yr real return figure for the S&P 500.

Is the data that could be used to apply a similar analysis to Berkshire available?
It'd be interesting to see how much of recent years' BRK performance could be attributable to low interest rates and corporate tax rates that might never return.
And what that analysis would predict for Berkshire's future performance (all else equal), for comparison to the +2%/yr real return figure for the S&P 500.

According to the paper, the three things that really boosted broad market returns were, fairly equally weighted:
* Multiple expansion
* Reduction in the cost of taxes and interest
* Growth in EBIT

Growth in EBIT is the normal thing, the one that isn't about to end. I imagine real GDP will continue to rise apace.
Berkshire has not had any benefit from multiple expansion in the last 15-20-25-30 years, so the end of that effect isn't a worry.
Berkshire typically owns more interest-bearing paper than it issues in interest-costing liabilities, so that probably isn't a big worry either.

But we certainly have had a benefit from tax cuts. From Berkshire's income statements:
Aggregate tax divided by aggregate EBT FY 1997-2002 inclusive was 34.57%
Aggregate tax divided by aggregate EBT FY 2011-2016 inclusive was 29.53%, before the 2017 cuts.
Aggregate tax divided by aggregate EBT FY 2019-2022 inclusive was 19.08% (around 1% lower if you skip 2020)

Compared to the very old period, our net profits (on the books) are 23.7% higher than they would otherwise have been.
Compared to the pre-TCJA period, our net profits (on the books) are 14.8% higher than they would otherwise have been.

However, there is one offsetting factor: most of Berkshire's assessed taxes were not paid, but deferred.
In effect, they reduced book but added to an invisible type of float.
Higher taxes will hit Berkshire for sure, but not quite as much as the income statement might lead you to believe.

So, putting it all together, I think Berkshire's growth will do fine, somewhere on the same-old same-old spectrum sliding slowly downwards from the usual rate of real growth purely because of size...
Except for rises in tax rates, which are hard to predict.
I have pencilled in an expectation that headline corporate tax will rise to 25%, which would result in a one-time reduction in after tax profits (reported) by about 5%.
Berkshire is one of the few big firms that pays close to the headline rate.

The other potential factor is that not only have stocks done well in the last few decades, but also the US economy.
It's possible that we'll see a tough decade or two in the land of Uncle Sam, so value growth would naturally slow along with that.
39% of Americans polled think that civil war is somewhat likely or very likely in the next decade.
17% think that in 20 years the US will not exist as all the current states under a single national government.
However unlikely or fringe those views may be, such things are not good for business if any of them actually happen.
It's always good to at least ponder the implications of outlier outcomes.

Jim

Some good discussion here. I always ask "give me your assumptions" to those who claim that past performance of the S&P index indicates it ought to outperform BRK going forward. They never provide them. Trends are nice, but some trends, such a falling interest rates, falling taxes, and multiple expansion can't go on forever.

WEB asked this question in 1999,

"The INESCAPABLE FACT is that the value of an
asset, whatever its character, cannot over the long term grow faster
than its earnings do.
Now, maybe you'd like to argue a different case. Fair enough. But give
me your assumptions. If you think the American public is going to make
12% a year in stocks, I think you have to say, for example, "Well, that's
because I expect GDP to grow at 10% a year, dividends to add two
percentage points to returns, and interest rates to stay at a constant
level." Or you've got to rearrange these key variables in some other
manner. The Tinker Bell approach'clap if you believe'just won't cut it."

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