Dear Fellow Investors,

We thought it would be very helpful to review Warren Buffett’s argument in 19991, the last time there was very high expectations attached to technology stocks and to the overall level of common stock prices. We will reference Buffett’s quotes by the year he said them. The sections labeled 2017 offer our current observations on the markets and thoughts from respected experts.

Buffett in 1999 “Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss. But I want to make one thing clear going in: Though I will be talking about the level of the market, I will not be predicting its next moves. At Berkshire (BRK.B), we focus almost exclusively on the valuations of individual companies. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.”

2017 Like Buffett, we recognize that we have no ability to predict market swings and we stick to our “circle of competence.” Buffett recently emphasized on CNBC that if interest rates stay low, investors aren't expecting enough from stocks. Dan Fuss, a 57-year veteran of the bond market and manager of the Loomis Sayles Bond Fund says, "We are keeping our maturities short for the coming normalizing of interest rates." We find it interesting that Buffett has talked more about one side of the interest rate movement coin rather than the more dangerous rising interest rate side.

Buffett in 1999 “Let's start by defining "investing." The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future--more money in real terms, after taking inflation into account.

Now, to get some historical perspective, let's look back at the 34 years before this one--and here we are going to see an almost Biblical kind of symmetry, in the sense of lean years and fat years--to observe what happened in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981. Here's what took place in that interval:

  • DOW JONES INDUSTRIAL AVERAGE Dec. 31, 1964: 874.12 Dec. 31, 1981: 875.00

Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move.

To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So, if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates in line.

The increase in equity values since 1981 beats anything you can find in history. This increase even surpasses what you would have realized if you'd bought stocks in 1932, at their Depression bottom--on its lowest day, July 8, 1932, the Dow closed at 41.22--and held them for 17 years.”

2017 We look at ten-year Treasury Bonds with a 2.23% interest rate and stocks trading at high historical levels in relation to earnings, book value and gross domestic product (GDP) wondering if the same case can be made for the next 17 years.

Buffett in 1999 “The second thing bearing on stock prices during this 17 years was after-tax corporate profits, which this chart [we have updated below2] displays as a percentage of GDP. In effect, what this chart tells you is what portion of the GDP ended up every year with the shareholders of American business.

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