The Serious Flaw in Warren Buffett’s Prediction of the Dow Jones

Will tomorrow be the same as yesterday?

Maybe. But there are no guarantees. Things do happen that can alter your carefully laid out plans.

You could win the lotto. You could fall in love. Your employer might go into receivership. Be diagnosed with a life-threatening illness.

There are so many good, bad and indifferent influences that can take the future on a very different path.

Extrapolating the past into the future is a flawed exercise. Things change…all the time.

Yet, when it comes to investing, we fall into the trap of believing things will never change.

WARNING: Here’s two reasons why the AUD could collapse in 2020

The collective thinking goes something like, whatever the conditions have been (good or bad), they will continue to be so.

However, all market charts show long term progress is never made in a straight line. The market zigs and zags its way to lower lows and higher highs.

I can hear the ‘but’ coming…‘but, over the very long term the share market has delivered solid returns’.

That’s true.

And it’s upon this foundation of truth that the platform for long-term predictions have been built.

Dow 100,000 points

On 27 August 2019, Yahoo Finance reported (emphasis is mine):

The Dow Jones Industrial Average started life on May 26, 1896.

An investor who acquired the whole index in 1896 has done relatively well over the past 122 years. The index has achieved an average annual return of 5.4%.

If the index continues to grow at this rate, I calculate it will only take 26 years for it to hit 100,000. That might seem overambitious, but it is only using the average annual return since inception. A more optimistic scenario might be to use the index’s average annual returns over the past 10 years, since 2009.

Have you spotted the error in this prediction?

No.

We’ll get to it shortly.

Dow 500,000 points

In November 2018, CNBC ran this story…

Ron Baron Dow Jones Prediction 15-11-19

Source: CNBC

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Here’s an extract (emphasis is mine)…

Buy-and-hold billionaire Ron Baron predicted on Friday that the Dow Jones Industrial Average will reach 500,000 in the next 50 years.

Speaking from his annual investment conference in New York, Baron told CNBC the stock market reflects the economy. Therefore, he argued, if gross domestic product doubles every 10 years, so will the market.

Extrapolating that out, Baron said in a “Squawk Box” interview: “The Dow Jones in 50 years will be 500,000.”

Ron has made the same mistake as the Yahoo Finance prediction (which we’ll get to shortly), but he has (literally) compounded it with an even bigger error.

For US GDP to double every 10 years, it requires an annual growth rate of 7%.

Ron then takes this assumed growth rate and extrapolates it 50 years into the future.

Wow. What could possibly go wrong with that?

For starters (using the Federal Reserve’s own data) US GDP growth — since 2006 — has been nowhere near the 7% per annum mark…let alone stay there on a year-after-year basis.

The Rum Rebellion US GDP Growth 15-11-19

Source: Federal Reserve Economic Data

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At least Yahoo Finance worked on an actual rate of return.

Dow 1,000,000 Points

Normally, if anyone told you the Dow is going to 1 MILLION points, you’d question their state of mind.

But this prediction was not made by just anyone.

In September 2017, Reuters reported (emphasis is mine):

{Warren] Buffett said he expects the Dow Jones Industrial Average to be “over 1 million” in 100 years, up from Tuesday’s close of 22,370.80. He said that’s not unreasonable, given how the index was roughly 81 [points] a century ago.

I’m going to climb further out on the limb here and boldly claim that Warren Buffett has fallen into the same trap as Yahoo Finance and Ron Baron.

The first error

The first error in all these predictions, is the starting point for the calculations.

Let me show you what I mean.

As the following chart of the Dow Jones shows, applying a compound rate of return to a market that’s close to or at its bull market peak is just plain dumb.

If you did this whole ‘I predict’ exercise in 1927, 1928 or 1929 you’d have ended up with a lot of egg on your face. Anyone who invested in the final years of the 1920 bull market, received an annual compound return (for almost 25 years) of, a BIG FAT…ZERO.

The Rum Rebellion Dow Jones Growth Chart 15-11-19

Source: Macro Trends

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Take a look at the current chart of the Dow Jones.

Do you really want to extrapolate that trend into the future…especially when you know that the market’s been goosed up by the most stimulatory measures in history?

Warren Buffet Dow Jones Prediction Analysis 15-11-19

Source: Macro Trends

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Each prediction — Dow 100,000 or 500,000 or 1,000,000 — has a starting point in the late stage of an ageing bull market.

Yahoo Finance crystal balls its numbers from the Dow’s current level. Ron Baron applies a ‘plucked from the air’ growth rate to last year’s high. These two are easy targets to shoot down.

But what about Buffett? Taking a tilt at the great man is never easy. But here goes.

In 2017, Warren Buffett expected the Dow Jones to be over 1 million points in 2117. He made that prediction when the Dow was at 22,370 points.

Let’s look at some maths.

Year Dow Jones start level Dow Jones point level in 100 years’ time Annual Compound return
1917 81 points 22,370 5.8%
2017 22,370 1 million 3.9%

When comparing the past growth rate — 5.8% per annum — with the expected growth rate — 3.8% per annum — Buffett’s prediction looks rather modest.

However, let’s assume the current — overvalued and overbought — market actually completes a full market cycle (going from boom to bust).

If the US market replicates past corrections, then it’s possible the Dow could fall to 10,000 points.

Let’s say this happens within the next few years.

Year Dow Jones start level Dow Jones point ending level Annual Compound return
1917 81 points 10,000 (in 2022) 4.7%
2022 10,000 1 million (in 2117) 5.0%

When start and finish levels are adjusted, you get a different result. Warren Buffett’s prediction doesn’t look quite so modest.

From 2022 to 2117, the Dow would need to outperform the compound rate of return from the previous century.

Is that possible?

The answer to that question, brings us to the second — and I think, more serious — error.

Extrapolating the gains of the 20th century into the 21st century.

With hindsight the 20th century was an extraordinary period of growth and development.

Can that past performance be repeated or are we going to be hamstrung by the legacies created from that period?

Debt. An ageing population. Welfare promises. Wage pressures from globalisation.

Applying the same straight line of past long-term performance to the future makes the assumption that tomorrow will be the same as yesterday.

And we know that’s not always the case.

In next Thursday’s Rum Rebellion we’ll look at why in my opinion, it’s unlikely.

In May 2017, The Gowdie Letter outlined why history will judge the 20th century a ‘purple patch’. A unique period that’s unlikely to be repeated in the 21st century.

The combination of — mechanisation; sanitation; medication; population and financialisation — delivered an unrivalled era of prosperity.

The legacy of this remarkable period is an ageing population; a mountain of debt; trillions in unfunded entitlement payments; and the coming age of automation.

Expecting the growth rates of this period to be reproduced over the next century is an error.

Here’s an edited extract from the May 2017 edition of The Gowdie Letter:

‘An investment in knowledge pays the best interest’

Benjamin Franklin

My desire to understand long term cycles, valuations and investor psychology motivates me to research economic and market history.

Which brings us to the biggest cycle in recent history…the 20th century.

Mechanisation. Sanitation. Medication. These three factors all contributed to a period of extraordinary human progress.

To appreciate the prosperity created during the 20th century, it is important to note this golden rule:

Economic growth can only come from two sources — an increasing workforce and/or increasing productivity. Please remember the rule as we go through the charts

In 1917, global population was estimated to be 1.9 billion. That number today is close to 7.5 billion.

Think about that…it took thousands of years to reach 2 billion and in the space of 100 years we add another 5.5 billion. That’s a significant increase in workers and consumers.

The Rum Rebellion 15-11-19

Source: Economica

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Over the next 100-years, UN data projects the global population will be over 11 billion…another 4 billion people.

Two points to consider here.

Firstly, the rate of population growth is slowing. The population nearly quadrupled over the past century and will only rise by 50% in the next century.

Secondly, can the world supply sufficient water, food and resources to 11.2 billion people?

Scientific research suggests around 9, possibly 10, billion people is all our earth can adequately support. Perhaps, biotechnology can provide solutions to the food and water constraints.

Either way, global population growth is slowing in quantitative terms.

In qualitative terms, it’s a different story.

When you excluded Africa’s projected population growth from the above chart, it appears the developed and developing worlds have, at best, reached ‘peak population’.

In Africa, there’s too much poverty, for too many people to make a significant difference to global consumption. It’ll take generations before any appreciable gains to impact the global economy. Today’s investors do not have the luxury of waiting generations.

The Rum Rebellion 15-11-19

Source: Economica

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Using the UN’s medium variant (red line) sees population flatlining in the decades ahead.

The low variant (green line) has us on a trajectory for declining population numbers.

Remember the golden rule for economic growth.

Increase workforce and/or increase productivity.

Strike one on the first component of growth.

Anyway, back to the 20th century.

The beauty of long-term trends is you can stand back and appreciate the broader landscape.

This next chart is a graphic of the interplay between demographics, interest rates, debt levels and GDP growth over the past 65-years.

The blue (and, red) bars represent the annual increase/decrease in 15-64 year old’s in the major economies. This cohort is considered the ‘productive’ contribution to the global economy.

The black line is the Federal Funds Rate (FFR) — the US cash rate.

That exponential red line is global debt.

The green line is global GDP.

The Rum Rebellion 15-11-19

Source: Economica

[Click to open in a new window]

From 1951 to 1981, the industrial world largely prospered from the ‘golden rule’.

Workforce increased. Productive output grew thanks to mechanisation. A dollar of debt produced a dollar of growth.

It’s little wonder that nostalgic voters want to return to that period of shared prosperity.

After 1981, the global workforce continued to increase. However, the West no longer had it on its own. The workforce increase was also occurring in countries that could provide lower cost labour. China, under Deng Xiaoping, began to reform its economy in the late 1970s.

Productivity gains had succumbed to the law of diminishing returns. Making machines faster only delivered marginal gains in output.

Slowly but surely, the ‘prosperous’ West resorted to financing their lifestyles with debt.

Consumption increased. The East was the ‘maker’ and the West was the ‘taker’.

Thanks to the East exporting its low labour cost to the West, inflation was on a downward trend.

Lower inflation resulted in lower interest rates. Lower interest rates fed into more borrowings. A virtuous cycle of debt and consumption in the West led to manufacturing growth in the East.

The world — West and East — became hooked on debt for growth.

This dependency has reached an unhealthy and destructive level.

The addicted economy now needs more than four dollars of debt to get a dollar’s worth of GDP ‘buzz’.

The legacy of the 20th century is — too much debt; too many Government promises; too little future growth.

Where to from here?

In January 2017, the Smithsonian Magazine published an article titled: ‘When Robots Take All of Our Jobs, Remember the Luddites — What a 19th-century rebellion against automation can teach us about the coming war in the job market’

The article begins with:

‘Is a robot coming for your job?

‘The odds are high, according to recent economic analyses. Indeed, fully 47 percent of all U.S. jobs will be automated “in a decade or two,” as the tech-employment scholars Carl Frey and Michael Osborne have predicted. That’s because artificial intelligence and robotics are becoming so good that nearly any routine task could soon be automated. Robots and AI are already whisking products around Amazon’s huge shipping centers, diagnosing lung cancer more accurately than humans and writing sports stories for newspapers.’

Let’s err on the side of caution and reduce the expected carnage in the US job market from 47% to 30%…that’s still a big number. Apply that percentage to developed and developing world workforces and ‘Houston we have a problem’.

Without employment how do you go into debt? If less people take on less debt (because they’re not sure if their job is next to be cannibalised), how does the debt funded economic growth model propel itself?

With less people in the 21st century workforce, who’s paying taxes to finance 20th century entitlements?

The good news is history shows us that new jobs will replace the old ones.

The bad news is that’s going to take a generation or two to occur.

We are more concerned with here and now. And that’s looking to be a whole lot different to the world of recent times.

On 3 May 2017, the Financial Times published an article written by David Eiswert, portfolio manager of global equities at T Rowe Price

The article was titled:

‘The era of ‘deflationary progress’ means betting on automation –

Investors need to come to reconcile themselves to the contradiction of progress and slower growth’

The concluding paragraph summarised the author’s outlook:

…there is more than politics and policy, demographics and debt slowing dollar GDP growth. There is a difference between stagnating statistics and the change and progress happening in the world. Automation is leading to a condition of “deflationary progress”. Investors and voters will have to come to terms with the contradiction of progress and lower growth.

It looks and feels like we are on the cusp of a major change in the dynamics driving economic growth.

Red tape; green tape; ageing Boomers; and, historical debt levels are all contributing to the governor on GDP growth. But, ‘wait there’s more’ according to Eiswert.

Throw in automation for good measure and economic progress is going to resemble that of a snail on Stilnox.

Back to our golden rule.

Increased workforce — unlikely.

In fact, the un and underemployment in the millennial demographic is estimated to be in the 10–20% range.

And for those fortunate enough to be employed, the news on the wage front is not as good as they would like.

In his book Average is over, Tyler Cowen wrote:

‘Inflation-adjusted wages for young high school graduates were 11 percent higher in 2000 than they were more than a decade later, and inflation-adjusted wages of young college graduates (four years only) have fallen by more than 5 percent.’

Increased productivity — possibly.

However, any gains are likely to be ‘deflationary progress’.

For example, Amazon driving efficiencies but with a cost to employment and at the expense of less efficient competitors. In a low growth world, growth becomes almost a zero-sum game. One company’s gain is another’s loss.

Without growth in the workforce and/or productivity, economic growth is going to be elusive.

On a day to day basis the world goes on about its business. Very little appears to change.

Same stuff, different day.

However, as I hope I’ve managed to demonstrate to you, under the surface there are strong currents of change.

Speaking as a baby boomer, when I was a young fellow, we fully expected to earn more than our parents. We had been conditioned to expect the next generation would live better than the one before. Not so today.

Ask a group of Gen Y and Millennials if they have the same expectation and my guess is the majority will answer in the negative. HECS debts, stagnating incomes, higher cost of living (rent), these are all growth retardants we Boomers never had.

The base is simply not there to repeat past levels of growth.

To maintain the illusion of growth we are seeing ballooning levels of public debt.

A fair percentage of this is being incurred for recurring expenditure…health and welfare spending.

Much has been said about borrowing for infrastructure spending. My guess is this will not be as economically productive as it is trumpeted to be. Anything Government and unions are involved in planning, inherently costs far more and delivers far less.

In summary, the components for growth are not there. The immediate outlook for the 21st century is it will be an equal and opposite force to what we witnessed in the final decades of the 20th century.

Perhaps, the Dow could rise to 1 million points in 2117. However, most of that compound growth may occur in the second half of the century…after we’ve dealt with the debt and entitlement legacy issues of the 20th century.

The problem for today’s investors is they don’t have the luxury to wait 50 years before markets resume normal compounding operations.

Buffett and I will not be here to see which one of us is correct.

But, hopefully we are both still around in the next five years to witness whether the Dow continues rising or completes a full rotation of the market cycle…boom to bust.

Regards,


Signature
Vern Gowdie,
Editor, The Rum Rebellion


PS:
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Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia. In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback. In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry. In 2013, he joined Port Phillip Publishing as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter. Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors. His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.


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