The Optimistic Prediction of Warren Buffett

In November 1999, Warren Buffett dropped a bombshell on investors when he wrote (with Carol Loomis) in Fortune magazine that the most likely average annual returns for investors in the market for the following 17 years would be 4%.

You may recall that, at the time, market participants were enjoying their fifth straight year of better than 20% returns. As the article noted, polls taken at the time showed those who had been investing for less than five years were expecting annual returns over the next 10 years of ... drumroll, please ... more than 22%! Even investors with 20 years of experience were expecting returns of 13%.

The triumph of the pessimists
Buffett argued rationally that such returns were mathematically impossible, barring occurrences such as long-term interest rates going from 6% (where they were at the time) to 1%, or corporate profits expanding well beyond their historical percentage of gross domestic product (GDP). Buffett postulated that when factoring in 1% average annual expense costs, real returns to investors should be about 4%. Including 2% annual inflation, nominal returns could be 6%.

The article was based on a speech that Buffett made in July 1999, a month when the S&P 500 touched 1,420.

Today, the S&P 500, after all the recent volatility, stands at 1,336.

"Nothing is good or bad, but thinking makes it so."
Let's unlock what is unquestionably good news from the lack of movement in stock prices during the past seven years.

Sure, investors who were in the market all that time have had a couple of wild rides merely to get back to where they started. But in the past eight years, three key things have happened:

1. Real corporate profits have actually grown faster than the 3% hypothesized by Buffett.
2. Long-term interest rates are no higher than they were in 1999.
3. Inflation has not been noticeably worse than expected.

So, the fundamental driver of stock returns -- real corporate earnings per share -- has been slightly better than what Buffett imagined might be the case. What's dramatically improved, however -- with better fundamentals at the same price -- is the valuations of stocks, particularly the large-cap stocks Buffett was talking about.

We need an example. Let's look at the rough valuations of some of the S&P 500's main components in 1999 and today:

Where does this leave us? The economy -- and by my calculations the performance of companies in terms of profits -- has exceeded what Buffett posited. Not wildly exceeded, mind you, but there was a slight edge. That result could turn out to be ephemeral, especially as corporate profits as a percentage of GDP are now quite high. If they return to the midpoint of their historical range while the economy grows at its usual rate, after-tax earnings growth will decline.

What lies ahead
I thought I'd run the numbers on what Buffett's original estimate would mean for the remaining 8.5 years of his 17-year forecast.

Over the past 8.5 years, the market has returned essentially (1.2%) in capital gains. Dividends have been on the order of about 1.6% on average, and inflation has been 2.7% annually. So real returns are negative to the tune of approximately 2.3% -- but let's call it 2%. For real market returns of 5% annually (ignoring, for the moment, the costs of investing) to materialize by 2016, we would need to see 12% real returns over the next 8.5 years.

Wait, 12% in real terms? That would be phenomenal. The historic average real returns of the market have been about 6.5% over the past 100 years. So are 12% real returns possible? Would Buffett really predict those types of 10-year returns today?

I highly doubt it. And I certainly won't put words into Buffett's mouth, because I'm pretty sure he -- or Charlie Munger -- would kick my butt for doing so. Literally. Which would be embarrassing. But I digress.

The long stagnation of stock prices -- in a time when corporate profitability accelerated and companies bought back record levels of stock -- means there's a great deal more margin of safety today than there was seven years ago.

Going beyond the S&P
Now might be a great time to get into the market. But, as is always the case -- and certainly as the past eight years have reminded us -- we approach this as long-term investors. One way to jump in is with a broad market index fund.

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This article was originally published on Aug. 9, 2006. It has been updated.

Bill Barker does not own shares of any companies mentioned in this article. Pfizer is an Inside Value recommendation. Johnson & Johnson is an Income Investor recommendation. The Fool has a disclosure policy.