Warren Buffett Needs a New Reason to Be Bullish on Stocks

(Bloomberg) -- Warren Buffett's Berkshire Hathaway Inc. will be holding its annual meeting this weekend. That means Omaha, where Buffett's investment vehicle and insurance firm is based, will be flooded with investors who hang on every word of the world's most famous stock picker.

If asked, Buffett is likely to say, as he almost always does, that stocks will continue to go up. Buffett is perennially positive, which is understandable. As the world's third-richest person, things have tended to work out for him. But Buffett has typically tried to back up his bullishness. If pressed this year, however, the Oracle of Omaha may have a harder time than usual justifying his rosy crystal ball.

Buffett has typically hung his stock market bullishness, or, in a few rare instances, bearishness, on the ratio that compares the total value of all publicly traded companies with gross domestic product. When the market cap of U.S. stocks collectively equal about 80 percent of GDP, as it did in early 2009, Buffett has said it is time to buy. When the value grows to 130 percent of GDP, as it did in late 2007, it is time to sell. The problem now is that the measure crossed 130 percent in early 2017 (it also reached that threshold in late 2015, before stocks dropped), and the stock market has continued to rise. It is now close to 150 percent, even with the market's recent wobbles.

So Buffett should be saying sell, right? Maybe not. There is reason to believe the gauge is not that useful anymore, or at least out of whack. The measure is essentially a giant price-to-sales ratio for the entire market. And companies with higher profit margins tend to have higher price-to-sales ratios. In general, though, corporate profit margins have tended to be higher than average over the past few years. And there is reason to believe, especially now that U.S. tax rates have been cut, that they will stay that way. That might mean Buffett's favorite stock market gauge should be higher than normal, though how much higher is difficult to say. Not to mention that the largest U.S. companies derive more and more of their sales and growth overseas, so comparing U.S. stock market values with the domestic economy might be less relevant.

Lately, Buffett's case for the stock market has rested on low interest rates. Yes, stocks look expensive, but they can stay elevated as long as interest rates stay low. This year, though, interest rates have risen, and as a result the valuation of stocks, as measured by price-to-earnings ratios, has dropped. Earnings, on the other hand, have risen. The combination means that stocks are basically flat for the year. Nonetheless, investors have seen for the first time the flip side of Buffett's low-interest-rates-equal-higher-stocks paradigm. Many think interest rates will continue to rise, though yields seem to have leveled out in the past few weeks.

This could be why Buffett, despite not backing off his bullishness, has tended to bring up the market less and less. In 2012, Buffett dedicated three pages of his annual letter to why he thought investors should buy stocks. This year's letter contained a warning on volatility and a chart of how much Berkshire's stock has dropped in the market's worst periods. Not that Buffett predicted a drop. He was just saying. It appeared as if his enthusiasm was wearing off. If Buffett's going to continue to tell investors to be bullish, he's going to need a new reason.

To contact the author of this story: Stephen Gandel at sgandel2@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.

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