Don’t Blindly Trust Warren Buffett’s Market Bets

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On Wednesday the most famous investor in the world — Warren Buffett — told CNBC that he doesn’t believe that stocks are too frothy. He is bullish on stocks for the long term, and he advised viewers not to sell their solid long-term positions. Is he right?

Despite his reputation, which is beyond reproach, Mr. Buffett gives no concrete evidence for his claims. Nowhere does he cite valuations, dividend yields price to earnings ratios, price to book values, or any other metric that one should use in determining the appropriate value of stocks. This is odd considering that his mentor — the famous Benjamin Graham — wrote two of the most influential books on investing — The Intelligent Investor and Securities Analysis — which spend hundreds of pages detailing exactly how one should use the aforementioned metrics in order to determine the value of a particular investment. In fact he has written a forward and provided chapter by chapter commentary for the former of these two works.

Investors looking at the valuation of stocks in the aggregate (i.e. as measured by the S&P 500) will find that they are historically quite “frothy,” and that while there are plenty of exceptions to this, the blanket claim that stocks are not frothy is not true by historical standards.

The S&P trades at 22 times earnings, yet historically it has traded in the mid-teens; 10 to 12 times earnings is usually a good entry point, and 13 to 17 times earnings is a good level to hold stocks, but not necessarily to buy them unless they have particular strengths, and anything higher is a good level to sell stocks unless again they have particular strengths.

Similarly dividend yields average less than 2 percent on the S&P 500. However, historically stocks have averaged between 4 percent and 5 percent dividend yields, and a stock was only worth buying with a lower dividend yield if it was a high growth stock. Furthermore, a good time to buy stocks before a bull market began was when dividends were as high as 8 percent.

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