We've reached another historic milestone for the U.S. stock market: The current bull market will officially become the second longest in history as of today's close -- with stocks lower in mid-afternoon trading on Friday. The S&P 500 (^GSPC 0.01%) and the Dow Jones Industrial Average (^DJI 0.03%) (DJINDICES: $INDU) are down 1.04% and 0.81%, respectively, at 2:10 p.m. ET.
Speaking to CNBC yesterday, legendary investor Carl Icahn predicted a "day of reckoning" for the stock market. Later in the day, when asked to comment, Berkshire Hathaway CEO Warren Buffett initially appeared to dismiss that dire warning (Yahoo! Finance went as far as to trumpet that Buffett "laughed off" Icahn's prediction).
Who's right, the folksy Midwesterner or the sharp-elbowed New Yorker? Both have been extraordinarily successful as investors: Buffett is the world's second wealthiest man, with a net worth of $68.6 billion, while Icahn is ranked 33rd, with a net worth of $20.3 billion, according to the Bloomberg Billionaires Index. As we will see, their opinions on the market are more similar than the headlines suggest.
First, let's start with what precisely Icahn said [my emphasis]:
I still am very cautious, yes. I'm extremely cautious about the market. It's not so much related to China, as related to the experiment we're doing -- and I'm not the only one that believes this -- that you can't have a Federal Reserve give low interest -- negative interest rates without creating tremendous bubbles and creating the wealth gap and it's doing a lot of things that -- unforeseen -- has unforeseen possibilities.
You know, it doesn't keep me from investing and we have a lot of long positions, but then we have a huge short position on and the short position, obviously, isn't working that well as the market goes up, but I have not changed my opinion that ... I do believe, in general, that there will be a day of reckoning unless we get fiscal stimulus and...
Here's how Buffett initially responded:
There are probably, this is the most wildest of guesses, there were probably 50,000 people or more today that bought stocks ... and 50,000 people who sold, so I don't know that I would pick out any one of them and put too much weight in what they did.
On the face of it, that looks like a weak counterargument. If every investor were of equal skill, it might hold, but perhaps it makes sense to place more weight on the words or deeds of the world's fourth-richest investor (behind Buffett himself, Buffett's friend and partner Jorge Paulo Lemann, and George Soros)?
However, note that Icahn -- like Buffett -- made his fortune buying and selling individual stocks, not making wagers on the level of the stock market. And as Buffett went on to say: "I have no idea what the market will do day to day, or why it did what it did today, or yesterday."
On the technical question of whether low interest rates can create asset bubbles, here's what the Oracle of Omaha had to say:
Interest rates act on asset values like gravity acts on physical matter. If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings. I mean if your alternative is zero and you know it will last forever ...
When interest rates were 15 percent with [Paul] Volcker, that was an enormous gravitational pull on the value of all assets, not just stocks, because an investment is something where you lay out money now to get more money later on, and if you can get 15 percent, it makes the choices way different than if you get zero.
And we've had low interest rates now longer than most people expected and, to some extent, it's changed people's expectancy about interest rates -- well, the 30-year bond reflects people's view about 30-year money.
[Note: The 30-year bond currently yields a piddly 2.70%.]
Buffett appears to be hinting that the stock market may indeed be overvalued to the extent that prolonged low interest rates have changed the market's expectations regarding how long low rates will last -- i.e., the market's revised expectations for low rates may have overshot what will eventually occur in terms of how long they prevail.
Furthermore, the risk is not only with regard to potentially inflated stock price multiples. When he was asked by the same interviewer to comment on the earnings season, Buffett said [my emphasis]:
Earnings have been so high. Corporate earnings have never been better. As a return on tangible equity, American business has never had it so good: Profits as a percentage of GDP, profit margins up and down the line, business has been very, very good ... So it's not surprising that if the economy is not galloping forward and you already have earnings at this level -- I don't see them jumping a lot from this level.
When one considers that valuations and earnings growth are the two major drivers of stock market returns, Buffett's message is sobering. Without giving in to alarmism, investors ought to keep their expectations in check.