This One Chart Has Warren Buffet Very Worried

The S&P 500 Index has hit 45 record highs thus far in 2014. But December has started off with a stumble. Is this a precursor to a larger decline?

Legendary investor Warren Buffet is known for his long term outlook; when he makes an investment he typically states he plans to own the shares forever.   But within his unshakable bullishness he still adheres to strict discipline of a value investor. Right now the gauge that he considers the most important is flashing a big warning sign.

The pace of profits exceeding economic growth is unstainable. Prepare your portfolio for a possible fall by using volatility options.

It is the ratio of corporate profits to Gross Domestic Profit (GDP) that has Mr. Buffet so worried. It has expanded rapidly over the past five years and now stands above 10% level, a historic high.

buffett-chart1

Buffet has referred to this measure at various times, most notable in a 1999 Forbes article in which he warned that euphoric dot.com bull market was not sustainable.

He mentioned it more recently during an appearance on CNBC last month saying he is having a hard time finding bargains and that the overall market seems “fairly priced.”   For the ever optimistic and long term bull this is tantamount to issuing a “sell” signal.

I’ll let Mr. Buffet explain in his own words from that 1999 article on why this ratio foretells a market decline.

Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that’s the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion.

So I come back to my postulation of 5% growth in GDP and remind you that it is a limiting factor in the returns you’re going to get: You cannot expect to forever realize a 12% annual increase–much less 22%–in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.

Some of the key takeaways from this deceptively simple concept are:

  • Shares are a claim on the future cash flow and profits of a company. Corporate profits cannot grow faster than the overall economy for extended period.   Mr. Buffet believes given an economy that’s growing at 3%-5% annually profits/GDP ratio above 6% is unstainable.

With the GDP posting 2%-4% increases over the past few years the current reading above 10% is extreme.   This must at some point experience a reversion.   It is much more likely that profits, and therefore stock prices will decline, rather than for GDP to increase by 10%. The latter would be unprecedented for an economy the size of the U.S.

  • His reference to corporate investors eating an ever growing slice of the economic pie was a prescient. Stock buybacks and dividends are now at historic levels. Corporations bought back $338.3 billion of stock in the first half of the year. This accounted for over 75 percent of net income for S&P 500 companies last year.According to Barclays, companies in the second quarter spent 31% of their cash flow on buybacks, the most since 2008 and up from 14% at the end of 2009.

Buybacks and dividends serve to drive compensation higher, enriching shareholders while diverting resources away from investment and innovation. In the long run the failure to reinvest in their own business will negatively impact future profits.

Mr. Buffet notes that the profits to GDP ratio has always been mean reverting and has followed classic business cycles. He doesn’t expect this time to be any different.

One area that Mr. Buffet might be too negative is in regards to profit margins. One of the biggest drivers of corporate profits has been expanding profits margins. Current margins, which are also considered to be mean reverting, are also at historic highs.

buffett-chart2

But there are some valid and possibly permanent reasons for the increase in profit margins, the most important being technology. Technology as a whole has improved efficiency across all industries and technology companies themselves, which have higher margins than old line industrial manufacturing, comprise a larger percentage of the S&P 500 Index.

But even if we awarded a permanent two percentage point shift higher in profit margins the current raise in share prices are at an unstainable rate.

buffett-chart3

As you can see most of the earnings growth has come from expanded profit margins. While we might have entered a high margin regime most of the increases captured through technology and job cuts have been realized.

Mr. Buffet remains long term bullish on the U.S. stock market, and so should you, he is clearly cautious at the current time. Unlike Buffet we don’t have the luxury of a “forever” time frame meaning we need to be prudent in how we deploy capital and assume risk.

Now is probably a good time to reduce overall market exposure. I’ve discussed the various ways options can be used to reduce risk while maintain upside potential. They range from a stock replacement strategy to hedging and portfolio protection.

The Trade:

A more proactive way to gain portfolio protection would be to gain exposure to volatility. Volatility typically increases as stocks sell-off as investors are willing to pay up for put protection.   The VIX is currently at just 14, or near the low end of its 10-year range. The purchase of call options on the VIX provides tremendous leverage.   My suggestion is:

-Buy VIX January $21 calls for $1.00 a contract

These options expire January 17, 2015 so it gives you coverage through the beginning of the New Year. I don’t have a specific price target but as a frame of reference it should be noted that the VIX rose to $31 during the October sell off.

Typically, for every 1% decline in the S&P 500 the VIX will rise 5%.   This, along with the leverage of options, is what gives this position so much bang for the buck.

— Steve Smith

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About the Author: Steve Smith