In a market driven by investor sentiment, the ability to separate hype from reality is a skill that can make the difference between significant gains and severe losses. It’s not uncommon to see stocks being overvalued for extended periods, a situation that often leads novices and even some seasoned investors to wonder how such a high market valuation can persist and what could bring it to an end.
Legendary investor Warren Buffett shares his insights on these dynamics, offering valuable guidance on navigating the stock market’s often irrational behavior. Drawing on decades of experience and his investing experience, Buffett offers a masterclass on understanding market ebbs and flows, the relationship between the economy and stock prices, and the psychological factors that drive investors.
Warren Buffett on Booms, Bubbles, and Busts
Let’s look at Warren Buffett’s lecture at the University Of Georgia in 2001 for his view on stock market valuations and how that can affect investing performance.[1]
“So GDP per capita in the 20th century in the United States went up 610%. Actually, qualitatively, it went up far more than that because you can’t really measure certain things in medicine, or whatever it may be, and improvements. But just on a quantitative basis, it went up every single decade, including the decade of the 30s. So, here you had a hundred years when basically, the U.S. citizenry was improving their lot decade by decade. The 30s, it was up 13%. The best decade was World War II, the 1940s; it was up 36%. The worst decade was the First World War.”
“Sometimes the analogy, you can get in trouble on analogies, but in any event, it was a huge period. Interestingly enough, there were six big periods in there for the stock market in both directions, there were three big bull markets. From 1900 to 1921, the Dow went from 66 to 71. That’s less than a 10% move in 20 years, less than half a percent a year. You got dividends too, but so, it didn’t move. From ’21 to ’29, as you point out, it went from 71 to a high of 381 in September of 1929. It went up 500%. Well, obviously, the well-being of the country didn’t go up 500% during that period.”
“The well-being of the country went up a whole lot more than 10% during that first 21 years. So, you got this very uneven development. From September 1929 until the end of 1948, the Dow went from 381 to about 180. It was cut in half, and that was 18 long years. Yet, the per capita GDP was moving right up during this whole period. So, the economy was doing fine. From ’48 to ’65, the Dow went again from about 180 up to close to a thousand, again, five for one, which was far outstripping it.”
“From ’65 to ’81, the Dow went down. Literally, well again, per capita GDP, and then we’ve had this last period where it’s gone up terrifically. If you take the whole hundred years, it went up 180 for one. Every thousand dollars became $180,000. But 43 and a quarter years, 43 and three-quarters years, were those three big huge bull markets, and 56 and a quarter years were periods of stagnation, all in an economy that was doing fine year after year after year.”
“56 and a quarter years, net, the Dow was down a couple hundred points during that period. And the other 43 and three-quarters years made up the rest of this move from 66 to 11,000-some on the Dow. So, you say to yourself, ‘How could it be that you could have a country that was doing better and better and better and better, citizens were living better every generation than the one that proceeded it, and yet you had these huge changes, big gains a few times, long periods of stagnation, 20 years?’ That’s a long time to do nothing.”
“The answer is that investors behave in very human ways. Which is they get very excited during bull markets, and they look in the rearview mirror, and they say, ‘I made money last year; I’m going to make more money this year, so this time I’ll borrow,’ or, ‘The neighbor says, I wasn’t in last year when that neighbor was dumber than I, made a lot of money, so I’m going to go in this year.’ So, they always look in the rearview mirror, and when they look in the rearview mirror, and they see a lot of money having been made in the last few years, they plow in, and they just push and push and push up prices. And when they look in the rearview mirror, and they see no money having been made, they just say, ‘This is a lousy place to be.’ So, they don’t care what’s going on in the underlying business.”
“It’s astounding, but that makes for a huge opportunity. I’ve lived through about half, in an investing sense, about half that period. I’ve had that long period of stagnation from ’65 to ’82, 17 years. I wrote an article for Forbes in 1979. I just said, ‘How can this be?’ Pension funds in the 1970s put a hundred and some percent of their new money in stock because they were wild about stocks. Then they got a lot cheaper, and they put a record low in nine percent of their net new money in 1978, when stocks were way cheaper.”
“People behave very peculiarly in terms of their reactions because they’re human beings, and they get excited when others get excited. They get greedy when others get greedy. They get fearful when others get fearful. And they’ll continue to do so, and you will see things you won’t believe in your lifetime in securities markets. The country will do very well over time, but you will see these huge waves. If you can stay objective throughout that, if you can detach yourself temperamentally from the crowd, you get very rich.”
“And you won’t have to be very bright. I’m sure you are, but it doesn’t take brains; it takes temperament. It takes the ability to sit there and look at something. When I started out in 1950, I would go through and find things at two times earnings, and they were perfectly decent businesses, and people wanted jobs at those companies. Everyone knew they were going to be around, and yet, they wouldn’t buy them at two times earnings and that’s when interest rates were two and a half percent.”
“I went to sell securities when I was 21. A Kansas City Life Insurance Company happened to be a fairly prominent company in Omaha. The policies they sold you, if you were buying life insurance from them, had a built-in assumption of two percent interest. The stock of Kansas City Life was selling at less than three times earnings. You were getting 35% if you bought the stock—no question about the soundness of the company.”
“I went to the local agent, and I thought, ‘I’ll be able to sell him a few shares of stock. The guy would understand. He’s got his whole life invested in this company.’ I said, ‘Mr. Moose, you know, you’re selling these policies with two percent. You may even have a few members of your own family on these policies, and you can buy into this company whose paycheck you depend on every month, and you know and whose future you, your beneficiaries of these life policies, depend on, and you’re selling them, you know, a two percent investment on, and you get 35% on your money.’ And he said, ‘Yeah, you know, stocks aren’t any good.'”
“And I couldn’t sell him. I was a lousy salesman, but it just blew me away. It blew me away. I thought sometimes I used to wonder if I was nuts. But those things, the same thing happened in 1964. The Dow closed at 864. At the end of 1981, 17 years later, it closed at 865. It moved one point in 17 years. Now, that’s not a big move.”
“And you can’t believe how discouraged people were during that period. But, you know, people were living better. So things can go on a long time that don’t make sense, but they do come to an end. The internet thing, for example, you had these companies selling for many billions of dollars that had no really practical prospects of making any money. That’s a bubble.”
“Herb Stein once said, ‘Anything that can’t go on forever will end.’ But think about that. Think about the next time you’re trying to do something just because the stock’s gone up a whole lot and your neighbor has made money. You’ve got to be able to sit and think objectively.”
“Think about it ‘Would I buy this whole business? An internet company’s got 100 million shares out, and it’s selling for $100 a share. That’s 10 billion dollars. Is it worth 10 billion dollars?’ If it’s worth 10 billion dollars it’s got to be able to give you seven or eight hundred million next year. And if it doesn’t give you seven or eight hundred million next year, it has to give you maybe ten percent more than that the year after and continue to do so. There aren’t a lot of businesses that can do that, and people just go crazy.”
“Of course, it’s fun. It’s like that sign they put in brokerage offices that says, ‘Avoid hangovers, stay drunk.’ It’s just so much fun to keep playing. But you’ve got to do sensible things to get good results.” – Warren Buffett
Key Takeaways
- Investors’ behavior often swings between extreme optimism and intense pessimism, leading to drastic movements in the stock market.
- These investor mood swings may not align with the economic reality of the business sector or the broader economy.
- Long periods of apparent stagnation in the stock market don’t necessarily reflect poor economic performance.
- Assessing a business’s real value is essential rather than getting swept up in market hysteria.
- Avoid the temptation to follow the crowd just because a particular stock is experiencing a surge in price.
- Maintaining a clear, objective market view can provide significant investment opportunities.
Conclusion
The narrative of stock market trends often seems dictated by collective investor sentiment rather than the underlying fundamentals of businesses. Legendary investor Warren Buffett stresses the importance of maintaining a rational, objective perspective to navigate these oscillations effectively. It’s not unusual for stocks to stay overpriced for extended periods, fueling what appears to be a growing bubble. However, remembering that such a state can’t last indefinitely is crucial. The ability to dissociate oneself from the crowd’s emotion-driven decision-making process and focus on actual business value distinguishes successful investors. In the long run, economic reality reasserts itself, and those who can discern this truth stand to profit immensely. As Buffett illustrates, achieving investment success doesn’t require brilliance, just the right temperament.