Data speak! What does Buffett find out from 100 years of stock market volatility in the United States?

In early 21st century, the Fortune magazine published Buffett on the Stock Market, in which Buffett reiterated that the overall performance of the stock market is linked to the overall growth of the U.S. economy in the long run, and that overpricing or underpricing stocks are bound to return to their intrinsic value in the long run.

1- Between 1964 and 1998, there is phenomenon that the overall trend of US stock market deviated completely from the trend of GNP.

The Dow Jones index moved quite differently from the first 17 years of 1964 to 1998 and the following 17 years.
In the first 17 years between 1964 and 1998, Dow Jones index moved from 874.12 at the end of 1964 to 875.00 at the end of 1981, and grew by 0.1 percentage points over 17 years, the index is almost exactly where it was.
In the second 17 years, Dow Jones index was 875.00 at the end of 1981, and was 9181.43 at the end of 1998, the price surged almost 10 times by the end of this incredible bull market.

But why the US stock market has performed so differently in these two 17-year periods?

The reason professionals have in mind is the fluctuations in the GNP lead to a corresponding fluctuation in the stock market, which is what the economics and finance textbooks often call "the stock market is the barometer of macroeconomics". But that is not the case. This phenomenon can not be explained simply by the fluctuations of the U.S. macro economy: 1964-1998 U.S. stock market overall trend and the trend of GNP completely deviated. In the first 17 years of the stock market slump, but U.S. GNP growth was 373%, while in the second 17-year period, the U.S. GNP growth rate was only 177%, while the stock had an incredible bull market.

Is it accidental coincidence or something else?

In fact, not only has the stock market in the past 34 years been a total departure from the GNP trend, but also throughout the 20th century. 20th century can be said to be an American century, has invented automobiles, airplanes, radios, televisions and computers. Excluding inflation, U.S. GNP recorded a net increase of 702%. Although it also includes the 1929-1933 Great Recession and the two world wars, compared to 10 years, it has been found that the real GNP per capita is growing every 10 years. Perhaps people think that stable economic growth is reflected in the stock market should also have a stable growth of the stock index, but the fact is far from the case.

Between 1900 and 1920, real GNP per capita (in 1996 dollars) rose by 33.7%, from $4,073 to $5,444, while the stock market did nothing, with the Dow Jones index at 66.08 at the start of 1900 and the Dow Jones index at 71.95 at the end of 1920, growing at an annual rate of 0.4% over 20 years, similar to that of 1964-1981.

Over the next 10 years, from 1920 to 1930, the stock market soared. By September 1929, the Dow Jones index had surged to 381 points, up 430%.

The Dow Jones index had almost halved in the 19 years between 1930 and 1948. In 1948, the Dow Jones index was only 177 points. But during the same period, the GNP rose by 50%.

Using a different time-division approach, the Dow Jones index has risen 11,000 points over the past 100 years over three periods, including 44 years, while experiencing three bear markets, including 56 years, during which the Dow Jones index has fallen 292 points.

So what is the cause of the stock market's performance and macroeconomic anomalies? See Warren Buffett's explanation below.

2- Three key factors affecting stock market volatility

Buffett attributes such anomalies to two key economic factors: interest rates, expected investment returns, and a psychological factor.

The first key economic factor affecting the stock market is interest rates. In economics, interest rates are like gravity in physics, and any small fluctuations in interest rates will affect the value of all the world's assets, wherever and whenever they are. If the market interest rate is 7% today, the value of your 1 dollars in future investment will be significantly different from the value of the market rate at 4%.

Analyzing the changes in long-term bond rates over the past 34 years, one can see that the first 17-year rate has risen sharply from 4.2% at the end of 1964 to 13.65% in 1981, which is not good for equity investors.

But in the 2nd 17-year period, interest rates fell sharply from 13.65% in 1981 to 5.09% in 1998, bringing the Gospel to equity investors. The 2nd key economic factor affecting the stock market is the expectation of future investment yield. In the first 17 years, investors expected a significant downward adjustment as a result of poor corporate earnings prospects. But in the early 1980 's, the Reagan administration vigorously stimulated economic growth, which made corporate profits reach an unprecedented peak since 1930.

For the first 17 years, from 1964 to 1981, two headwinds caused investors to lose confidence in the US economy, partly because of poor corporate profits in the past, and partly because interest rates were so high that investors greatly discounted their expectations of future profits. Both factors combined to cause the US stock market to stagnate during the 1964-1981 period, despite a huge increase in GNP over the same period.

But these factors reversed completely in the second 17 years, from 1981 to 1998, with sharply higher corporate yields and falling interest rates raising investors' expectations of future corporate profits. These two factors fuelled a bull market that saw a sharp rise in the stock market while the GNP fell.

The third was the psychological factor that people see the stock market surge and lead to speculative frenzied trading.

3- Quantitative measures of whether the stock market is too hot or too cold

Buffett believes that looking back at the performance of the stock market over the past 100 years, one can see that the overall trend of the stock market has often diverged from macroeconomic developments. This extreme irrational behaviour is cyclical. People recognise the significance of this phenomenon for investors. If they want to make good returns on the stock market, they should learn how to deal with the explosion of irrational behaviour in the stock market.

Buffett believes that in order to remain rational in the stock market irrational fluctuations, one of the most important is to learn quantitative analysis, so as to be able to accurately determine whether the stock market is too hot or too cold. If investors can carry out quantitative analysis, although they will not be able to improve the analytical ability to superhuman level, but they can thus avoid drifting into the stock market with the crowd of the high prices crazy, make irrational decisions if investors can be based on the quantitative analysis of the rational choice of the stock market, if investors can no longer find out of rational quantitative analysis.

Buffett recommended to American investors a very simple but very useful quantitative measure of the stock market as a whole "the ratio of the total market capitalisation of all listed companies to GNP".

Although the ratio of total market capitalisation to GNP of all listed companies gives limited information to investors, it is probably the single best indicator of whether a company's value is justified at any time. An analysis of the ratio of total market capitalisation to GNP of all listed companies over the past 80 years reveals that this indicator reached an unprecedented peak in 1999 and would have been an important warning sign that if the rate of increase in wealth of all listed companies was in fact higher than the rate of aggregate market capitalisation of US macroeconomic growth.

Buffett believes that buying stocks at 70% to 80% of GNP in total market capitalisation for all public companies may pay off fairly well for investors in the long run, but if the ratio reaches 200%, as it did for some time in 1999 and mid-2000, buying shares would surely be a fiasco.

4- The stock market is unpredictable in the short term and easy to predict in the long term

Buffett believes that it is impossible to predict short-term fluctuations in the stock market. On the contrary, Buffett believes that long-term fluctuations in the stock market have a very stable trend, very easy to predict.

In 1999, Buffett boldly predicted the next 10 years or even 20 years, U.S. investors stock investment expected rate of return (including dividends and expected inflation rate of 2%) about 7%, which coincides with the statistical analysis of Professor Jeremy Seagal Watton.

5- Inspiration

Over the past 200 years, the annual compound real rate of return on US equities has been 7 per cent and has shown remarkable stability. The real rate of return on equities in other major countries of the world also coincides with that in the United States. The reasons for the long-term stability of the rate of return on equity investments have not been well explained.

Professor Jeremy Siegel argues that the rate of return on equity investment depends on the return on economic growth, productivity and risk. But the ability to create value also comes from effective regulation, stable political systems that respect property rights, and the willingness to provide value to consumers in a competitive environment. Political or economic crises can cause equities to deviate from their long-term direction, but the dynamism of the market system allows it to return to long-term economic returns that may have influenced economic stability throughout the world.

No one has been able to fully explain the root cause of the stock market's long-term return to inward value. This is one of the mysteries of our industry, Graham once said. It is as magical to me as it is to anyone else. But we know from experience that the market will eventually bring the share price to its value.