The last few months has been defined by one subject: Trade. More specifically, trade with China. For a good month or so, it appeared the U.S. and China were very close to coming to a new trade agreement and now, according to the powers that be in the White House, our trade partner essentially got cold feet. So, back to the drawing board. Much of this news (and non-news) is reflected in the stock market gyrations.
We can talk at nauseam dissecting trade, tariffs, etc. but we won’t. Let’s just sum this up with 1) tariffs over the long-term are bad for all parties involved, and 2) the economies of both superpowers would be better off as trade partners. Everyone knows this and everyone knows the U.S. needed to take this stance (probably over a decade ago). And when I say “everyone,” that includes China. So, expect some resolution.
Now that we got that topic digested, let’s move onto the real topic of this commentary… the annual gems that come out of the Berkshire Hathaway annual shareholder meeting (and subsequent interviews). Every year, we are treated to the insights of two of the greatest investors who have ever walked the Earth; Warren Buffett and Charlie Munger. They share thoughts on a number of topics (that are all worth reading), but this time around one quote from Mr. Buffett stands out to me: “I think stocks are ridiculously cheap if you believe ... that 3% on the 30-year bonds makes sense.”
Ah… interest rate talk! An important topic (and its influence) we have written about in the past. What Mr. Buffett was referring to is reflected in this chart… the relative value of stocks (S&P 500 earnings yield) compared to the yield of bonds (10-yr treasury).
In a nutshell, the idea is that the earnings yield on stocks and the yield on bonds should follow each other. If bond yields go up (making them cheaper), then they become more attractive relative to stocks, which then must become cheaper to become attractive. The opposite is where we find ourselves today, bond yields are low, and with the earnings yield where it’s at, stocks look cheap… “ridiculously cheap” according to maybe the greatest investor of our time. This definitely provides a level of comfort for equity investors. (For what it’s worth, we are still finding good value, so we agree.)
But, what about the second part of Mr. Buffett’s statement: “if you believe … that 3% on the 30-year bond makes sense.” He is alluding to the fact that this is very low and quite frankly, it will not sustain itself over the long-term (i.e., something needs to change). It’s tough to argue with him on this, but people have been waiting for interest rates to ascend for some time (especially after the decline of interest rates over the past 35 years).
While we don’t try to predict interest rate movement over the short run, we do agree that eventually they will go up. But let’s dissect this a little more. Over time, how high can they go up? Where will they peak? Looking at this chart of the 10-yr treasury, interest rates will be hard pressed to ever reach historical highs set in the 1980’s. In fact, rates would have to move quite a bit to even reach the level of the late 1990’s / early 2000’s.
The point is, even with the inevitable rise in rates, we will still be living/working/investing in a pretty favorable interest rate environment. And as we know, interest rates are somewhat important in our world… if you don’t believe me, just ask Señor Buffett!