Dow 1,000,000
Warren Buffett predicts that the benchmark will hit that number by 2117. That’s a modest goal, but one that could be difficult to reach.
“It’s tough to make predictions, especially about the future,” Yogi Berra supposedly said, as he channeled Niels Bohr, the atomic scientist.
Not so for David Meade, a so-called Christian numerologist who has been predicting that the apocalypse will arrive on Sept. 23, which, if correct, would mean you’re probably not reading this. He based this prediction on prophesies he gleaned from the New Testament, but like any good forecaster, he revised it late last week. “The world is not ending, but the world as we know it is ending,” he said to the Washington Post. Either way, Meade evidently skipped over the admonition in Matthew’s Gospel, that “you do not know the day or the hour.”
At the other extreme, Berkshire Hathaway’s Warren Buffett offered a far happier forecast last week: The Dow Jones Industrial Average will reach 1,000,000 in a century. Yes, 1,000,000, with six zeros, a seemingly incomprehensible feat, relative to Friday’s close of 22,349.59.
Yet the Sage of Omaha actually was proving Einstein’s purported observation that “compound interest is the eighth wonder of the world.” To reach 1,000,000, the Dow would have to increase at a compound annual rate of just 3.87% for the next century. That moved longtime Barron’s Roundtable sage Mario Gabelli to quip in a tweet, “Has Buffett turned bearish?” In actuality, over the past 100 years, the Dow’s compound annual growth was 5.5%, boosting the index from 95 at the end of 1916 to 20,069 this past January.
That doesn’t take into account the effect of inflation, however. With inflation averaging 3.1%, the Dow’s real compounded annual growth rate was 2.3%, according to the R Street Institute, a free-market think tank. Inflation over that span meant that at the end of 2016, it took $2,116 to buy what $100 did in 1916, based on Bureau of Labor Statistics data. (As a frame of reference, 1916 was two years after the Federal Reserve began operations.)
Although Buffett’s prediction represents a relatively modest goal for 2117, given the magical math of compounding, the mention of such big, round numbers for the Dow echoes hubristic forecasts that tend to appear around market tops. The most notorious was the book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market, published in 1999, just before the dot-com bubble burst.
The Dow was supposed to hit that vaunted 36,000 level by 2004. Moreover, the authors asserted, equities were no riskier than riskless government securities, and therefore shouldn’t have any risk premium (that is, the required return over the risk-free interest rate), even though Treasury securities, unlike stocks, come with a money-back guarantee, at maturity, at any rate. Well, we know how that turned out. From a peak of 11,722.98 in January 2000, the Dow plunged to 7286.27 by October 2002, and wouldn’t top the previous high until October 2006.
Buffett’s mathematically modest expectation of a 3.87% compounded annual rate of return is more defensible. Assuming no expansion of the price/earnings ratio—now approximately 18 times expected earnings on the Standard & Poor’s 500 index—stocks should track the increase in corporate profits. That, in turn, should parallel the growth in the U.S. economy.
Assuming 2% inflation, the Fed’s as-yet-unattained target, that means roughly 2% real growth is needed to produce 4% nominal growth. Real growth consists of labor-force increases multiplied by gains in productivity. On the former, the fertility rate in the U.S. has slid below the replacement rate (2.1 children per woman over her lifetime), which limits the size of the labor force without immigration. As for productivity, it remains sluggish, growing at just 0.6% annually since 2011.
Economist Robert Gordon has been a prominent dissenter in projecting the prosperous past of the U.S. into the future. He foresees productivity growth of 1.3%, well below the 2% achieved from 1891 to 2007. In his much-discussed 2012 paper, he concluded that the information-technology revolution of the internet and mobile phones hasn’t brought gains similar to those of the “second industrial revolution” (electricity, the internal-combustion engine, running water and indoor plumbing, communications, entertainment, petroleum and chemicals), which generated robust 20th century economic growth.
In a 2014 follow-up, Gordon added that the U.S. economy faces four headwinds: demographics (baby boomers retiring, plus lower labor-force participation by people of working age); plateauing of educational attainment; growing income inequality; and increasing debt, which will force higher taxes or reduced transfer payments in the future.
In terms of demographics and debt, Japan offers an example. The Nikkei 225 peaked at the end of 1989 at just shy of 39,000, almost twice Friday’s close of 20,296.45. In the 1980s, many predicted that Japan would rule the global economy, just as many expect of China. On the latter score, S&P lowered its rating on China’s sovereign debt last week to single-A-plus from double-A-minus, owing to too-rapid credit growth.
Buffett suggested that it is foolish ever to bet against America. He, along with most Barron’s readers, has been lucky to live through a golden age for the U.S. economy. Perhaps the future will be like the past. Maybe it will be better, maybe it won’t.
Attainment of a 4% nominal growth rate for the U.S. economy, implied by his Dow 1,000,000 prediction, may seem like a modest goal, but we’re falling short of it currently.
Godot has finally arrived. The Federal Open Market Committee last week announced that the long-anticipated shrinkage of the central bank’s $4.5 trillion balance sheet will begin in October.
To review the mechanics of monetary policy, when the central bank purchases securities, it pays for them with money created out of thin air, which then goes into the private economy. Conversely, when the central bank sells or redeems those securities, the real cash it receives is withdrawn from the economy. So, as the Fed allows its Treasuries and agency mortgage-backed securities to mature, Uncle Sam and his niece, Fannie Mae, and nephew, Freddie Mac, will have to replace those funds in private markets. Some of the $2.2 trillion of excess reserves sloshing around the banking system will probably be taken up in the process, which will still leave a surfeit for some time.
This, however, fails to capture the reality of a world in which money crosses borders freely in search of the highest returns. The Fed isn’t the dominant player around the globe by a long shot, notes Mark Grant, chief strategist of Hilltop Securities. Citing data from Yardeni Research, Grant points out that the People’s Bank of China has the Fed beat with $5.2 trillion in assets, followed by the European Central Bank with $5.1 trillion and the Bank of Japan with $4.7 trillion. The money created by the Fed is no different than that from the Swiss National Bank, the ECB, or the BOJ, Grant observes. And that foreign money heads to American shores for higher returns than its home markets’ sub-1%, or even negative, yields.
Similarly, JPMorgan economist Nikolaos Panigirtzoglou writes, the shrinkage of the Fed’s balance sheet will be offset by the central banks of the other G4 countries. JPMorgan estimates that the Fed will shrink its balance sheet by about a third, to $3 trillion, by 2021. But that will be mitigated by estimated ECB monthly purchases of 40 billion euros ($47.8 billion) of bonds in the first half of 2018, €20 billion in the second half, and no more after that. The BOJ is also projected to buy 60 trillion yen ($535.77 billion) a year.
“The Fed’s cutback is about $300 billion a year, while the other central banks are pumping in $300 billion a month,” as Hilltop’s Grant points out. “The money will go somewhere and, given that American yields are so much higher than those in Japan or Europe, a lot of it will find its way here.”
Jesse Fogarty, who manages U.S. investment-grade corporate debt for Insight Investment, a unit of BNY Mellon Investment Management, remarks that there has been a persistently strong bid for U.S. corporate bonds from global buyers—especially since the ECB began buying European corporates.
Fed Chair Janet Yellen insists that running down the central bank’s balance sheet from its crisis levels should be as uneventful as watching paint dry. While its counterparts abroad continue to expand their assets, the impact of the Fed’s shrinkage should be limited. Yellen also says that the Fed’s main policy tool will remain the federal-funds rate, which the FOMC indicated is on course for another quarter-point hike in December, from the current 1% to 1.25% target range.
In addition, the FOMC has penciled in three more hikes for 2018, based on its so-called dot plots. Less certain is who will be making those calls next year, given that Yellen’s term as chair will be up. In addition, until the Senate confirms Randal Quarles’ nomination, there will be four other vacancies on the seven-member Board of Governors after Vice Chairman Stanley Fischer retires next month.
Perhaps the most important fact to emerge from last week’s FOMC meeting is that the panel further lowered its estimate of the long-term “neutral” federal-funds rate by a quarter-point, to 2.75%. Put together with the dampening effect from foreign central banks on the Fed’s balance-sheet reduction, that points to bond yields remaining lower for longer, which is consistent with a low-growth U.S. economy.