Buffett, Munger, and Exploding Markets

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Of all the quotes that caught my attention at last week's Wesco Financial (AMEX: WSC  ) gathering with Charlie Munger, this one surprised me the most: "Low interest rates have driven stocks up. People look at the yield on two-year treasuries with great despair."

A few days before, the same thought was echoed by both Warren Buffett and Munger at the Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual shareholder meeting (as quoted by the Wall Street Journal):

Buffett and Munger said that they believe the stock market rise is a result of individual investors who are reacting with dismay to low interest rates. Retail investors are moving away from money market funds that pay next to nothing and getting into stocks.

What's surprising about this? How easy it is to refute.

Happy to earn next to nothing, thank you very much
Theoretically, the idea makes perfect sense. Since stocks and bonds compete for investors' attention, low interest rates can make bonds less attractive than riskier investments like stocks. So, if a bond yields 2% while a stock yields a 3% dividend and can grow earnings by 5%-10% a year, then stocks start looking seriously superior, and rational investors will, the textbooks tell us, reallocate bond investments into stocks.

Problem is, we aren't rational investors. On whole, we're mildly nuts. Data from the Investment Company Institute shows that by an order of magnitude, investors are still drowning themselves in bonds and steering clear of stocks.

Since the explosive stock rally began last March, investors put only a net $49 billion into stock mutual funds versus nearly half a trillion dollars into bond mutual funds. During the last four months of 2009, investors actually pulled $23 billion out of stock funds while dumping $155 billion into bond funds. Going back to January 2008, there isn't a single month where stock inflows outpaced bond inflows. It isn't even close. Even from February to April of this year -- a particularly thriving period for stocks -- bond inflows were nearly quadruple stock inflows. If investors are looking at bond yields with great despair, their actions sure don't show it.

These numbers are pretty straightforward: Investors are still cautious about stocks but can't get enough of bonds -- just the opposite of Buffett and Munger's theory.

So what's going on?
If investor participation hasn't fueled the rally, what has? Well, low interest rates can also juice stocks by making it easier to justify higher valuations. Basically, it's worth paying what seems like a premium for stocks because the returns can still be better than low-yielding bonds.

But what's really interesting is that some valuation metrics make it hard to tell whether much of a "premium" has been priced in during this rally. For example, look at this chart of consensus forward-looking earnings estimates on the S&P 500:

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

This shows that as stocks have surged, and so have earnings estimates. By this metric (and there are many), valuations over the past year haven't risen significantly, if at all. In fact, earnings estimates have grown faster than stocks for most of the past year. That, in my view, has been the main driver behind the market's upward explosion. It's not about an influx of investors who are disenchanted with the low returns of bonds. It's about earnings.

You don't need to look hard to find specific examples of this. One year ago, Ford (NYSE: F  ) was nearly dead. Now it's expected to earn $1.59 per share next year. Last winter, the chatter around Bank of America (NYSE: BAC  ) was about nationalization. Now it's about record revenue. In April 2009, the economy lost 539,000 jobs. In April 2010, it gained 290,000. You can't judge the market's run-up without acknowledging these catalysts, all of which have exactly nothing to do with the theory that low interest rates are driving investors out of bonds.

Now, Buffett and Munger may be right that low interest rates have contributed to stocks' surge by padding earnings, particularly in the financial sector. Actually, that's undeniable. But what low interest rates have not done, as the numbers show, is lured investors back into stocks in any meaningful way.

What do you think? What do you think has been behind the market's explosion of the past year? Fire away in the comments section below.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value pick. Berkshire Hathaway and Ford Motor are Motley Fool Stock Advisor selections. The Fool owns shares of Berkshire Hathaway and has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (19)

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  • Report this Comment On May 11, 2010, at 11:44 AM, cbcs wrote:

    All of this is good information, but in the end, the question still remains: what are investors supposed to do NOW? Stocks are at 52 weeks highs (even after the pullback they are close to the top), commodities are through the roof, national debt is skyrocketing, Europe has delayed its day of reckoning (through more money being injected), but that's not sustainable. Real estate, although up slightly, is only up off a miserable bottom and foreclosures are increasing. Unemployment is 10%/17%.

    What does an investor do at this point?

  • Report this Comment On May 11, 2010, at 12:43 PM, willbace2010 wrote:

    very interesting!

  • Report this Comment On May 11, 2010, at 1:02 PM, stevepoddy wrote:


    FRANCE TELECOM etc.Their DIVIDEND is from 6%

    to 8%.These are European Utilities,Very BIG ones.......

    Risky? WMT,PG,JNJ.......

    The Euro? May be,but you can hedge.

    So what?

  • Report this Comment On May 11, 2010, at 1:13 PM, thehobe wrote:

    The V shaped recovery is no mystery; The dramatic selloff that drove the Dow down to extreme lows in 2008/9 was FEAR. Stocks have inherent value but fear drives the volatility and sharp selloffs result. The market overdid itself due to this fear and the drop was the result. At some point, investors are willing to take the risk and begin to purchase stocks again and the V is the result. Stock prices overshot on the way down and the V is just the correction to the "mood" of individuals. No one seems to quantify the "mood" factor when analyzing stock prices. The V is now done and further increases in the Market will come from fear reduction over time--time heals and people's memories are short lived when the greed of higher profits sets in. The market is driven by fear and greed as we al know and we are just coming out of very fearful times. Two years from now, the fear wil turn back into greed.

  • Report this Comment On May 19, 2010, at 9:54 PM, 8Lives wrote:

    My sentiments EXACTLY thehobe. The "mood" of the average investor is what fuels market fluctuations in general.

  • Report this Comment On May 20, 2010, at 2:30 PM, susan400 wrote:

    How could it be otherwise? ait is all there.

    millions finally give in and buy stiks because

    MMF is .25,,,,,

    those are people whom you WANT to sell to,

    not joing and bu with.

    coul;dn't be more clear.

    when rates are well 9t?

    then janjoe will sell and you want to buy.

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