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Warren Buffett's Take on Stock Market Corrections Lombardi Letter 2018-07-23 13:17:49 warren buffett market predictions 2018 warren buffett predictions warren buffett advice for the stock market warren buffett advice for investment warren buffett on investing warren buffett indicator warren buffett market forecast warren buffett on market valuation With the Dow Jones dropping below 24,000 points for the first time since last November, Warren Buffett’s advice for stock investors might be the same he gives his grandchildren when they get into a car: fasten your seatbelts. Analysis and Predictions 2018,News,Stock Market,U.S. Economy,U.S. Politics https://www.lombardiletter.com/wp-content/uploads/2018/11/warren-bufett-indicator-150x150.jpg

Warren Buffett’s Take on Stock Market Corrections

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Credits:Jamie McCarthy / Staff/Getty Images

Warren Buffett Market Predictions 2018

By Tuesday, the market correction of Black Monday 2018 (February 5, 2018), seemed like a mere break. Investors indulged in a little profit-taking to pay the Christmas bills or the Caribbean getaway from the especially cold winter. Yet, on Thursday, rather than continue its recovery, the Dow Jones Industrial Average (DJIA) took another steady dive, seeking a new low for the year to date. Once is a fluke. But two crashes in the same week?

That starts to look a lot like 1929. There is real fear in the markets that the very thing that drove the Dow and the Nasdaq to lofty records at the start of 2018 could be the cause of their ruin in February. In fact, what we are seeing on the markets is one of Warren Buffett’s predictions for 2018.

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Warren Buffett is no contrarian. He does have an optimistic outlook for the U.S. economy in general over the next 100 years. Yet, the world’s most famous investor and CEO of Berkshire Hathaway Inc. (NYSE:BRK.A) has at least 30% of his holdings in cash. How could that be?

Clearly, Buffett proffers predictions that he himself believes. He literally puts his money where his mouth is. Buffett says he hates having to hold so much cash. But he hates expensive stocks even more. (Source: “The best prediction for 2018: Beware of conventional wisdom about the stock market and an election 10 months away,” MarketWatch, January 2, 2018.)

You don’t need to verify the Warren Buffett predictions on the economy. Conveniently, if sadly, they are materializing before our very eyes. Buffett and other masters of finance—like Ray Dalio, for example—have been sending the warning salvos for months. The message may use different terms and examples, but when stripped down to its essentials, the idea is clear and simple. The market is too expensive. Stocks have an average 27 times price-to-earnings ratio. That means whatever earnings they may accrue in the coming year, their valuations are already reflecting them.

In the short term, this makes Wall Street, in particular, vulnerable to all kinds of shocks, from the financial to the economic and the political. In the longer term, it places the entire world economy in peril.

Warren Buffett’s Advice for the Stock Market

You are still in time to take Warren Buffett’s advice for the stock market. Buffett has set the example. The fact that he has a much larger cash position than he would like—by his own admission, he doesn’t like cash—is the advice; he sees a strong cash position as the best hedge against the inevitable shocks to the economic system in 2018. They’re already here.

What Buffett understands, which many investors fail to realize, is that the incredible market performance of the past few years is simply the result of two interrelated factors: the lowest interest rates in U.S. history and the Federal Reserve’s willingness to spend some $4.5 trillion in government bonds (Treasuries) and mortgage-backed securities to encourage investors to choose equities instead.

In sum, the Federal Reserve has pushed risk at the expense of safety. The effect on the markets has been nothing short of a greed-equivalent to Lionel Richie’s party favorite, All Night Long. But now, morning is coming and the hangover is about to start.

The Hangover

President Obama still likes to take—and he’s rather funny and charming about it—swipes at Trump’s boasting about the economy. The point of the jokes, for those who get them, is that Obama was the one who set the economy and the markets on their incredibly bullish course. In fact, neither Obama nor Trump should take any credit for Wall Street’s success. That’s the Federal Reserve’s privilege. If anything, Trump has screwed up.

President Trump and Congress enthusiastically passed a historic tax reform. But the reform is the equivalent of adding a nitrous oxide boost to a car too early in the race. Or, if you prefer, having one too many drinks at the company holiday party. No matter how good the conditions and the chances of success, there’s always a need for balance or equilibrium. Trump’s taxes have produced too much of a turbo-boost, pushing the Dow too high and too fast, while also raising wage increase expectations. Nothing scares the Fed more than the risk of inflation.

Trump’s tax cuts and interest rates represent nothing short of a recipe to boost the economy out of recession. Applied when the economy is already at full speed, they trigger the inflation-alert button. So, the short answer to why the stock market will crash in 2018 is a paradox. Because they have done so well taking the low interest rates, the Federal Reserve’s pullback will be the equivalent of a doctor taking a diabetes patient off insulin. The low interest rates were never a cure against recession, they were merely a treatment.

Warren Buffett Advice for Investment

The first full week of February has been the worst in the last decade as far as the world’s stock markets are concerned. But, none more so than the U.S. stock market. Seeking the advice of the likes of Warren Buffett on investment in what has clearly become a volatile financial situation is almost a gut reaction. Yet, Buffett was sending his advice long before the exuberance reached an “irrational” level. He found stocks too expensive when the market was in full bull mode.

Look at the Warren Buffett Indicator. This is a metric that weighs the total capitalization of U.S. stocks compared to gross domestic product (GDP). It’s essentially a way to measure stocks’ performance relative to the overall economy. In October, that metric stood at almost 140%. The only time it was higher was at the peak of the 2000 dot-com bubble. (Source: “Warren Buffett’s favorite stock market indicator is calling the top,” Business Insider, November 1, 2017.)

The Dow Jones lost 4.6%, regained half, and then lost even more to drop below 24,000 points for the first time since last November. Stocks have given up all their Trump tax plan gains and more.

Warren Buffett Market Forecast

Warren Buffett’s market forecast is as simple as it is harsh. He expects at least one major market correction in 2018. We’re only a few days into February and you can understand why people like to describe Buffett as the “Oracle of Omaha.” His prediction has already come true. Buffett understood that a correction was due, realizing that Wall Street’s exhilarating ride in 2017 had no solid financial or economic reason for being. It was pure greed.

Now that predictions have become reality, it’s important to understand what informed Warren Buffett on market valuation. Or, better, why have the markets dropped now. The first reason that Buffett might suggest for a crash is that the market has seen a period of almost uninterrupted growth. The Dow Jones has gained over 25% from January 2017 to January 2018 and that’s simply unprecedented. Therefore, even the lesser oracles could have predicted a crash in 2018.

Moreover, the sudden and almost blitzkrieg-like nature of the February correction was a surprise. Or, at least nobody expected a correction so quickly, not even Buffett. It was like the sight of lightning in a beautiful blue and sunny sky with no clouds on the horizon. There was no accumulation of bad news as in the protracted 2007-2008 financial crisis. Indeed, the global economy itself—not just the American—is growing at the best pace in a decade.

It’s the Federal Reserve’s response—and the uncertainty about when the measures will arrive—that has everyone in a panic. The Fed could raise interest rates three times in 2018. In stock market terms, this means that the average investor will have to take cover, avoiding or pulling out of riskier stocks in favor of safe havens like gold, perhaps. (Those who have a devilish attitude to risk might try Bitcoin.) The inevitable result is that stock valuations on Wall Street will fall, or worse.

The funny thing is that the interest rate warning had been out for some time. But it seems, like procrastination over a feared dentist appointment, there’s always the hope that somehow the pain—or the risk, in the market’s case—will go away all by itself. Had Trump not raised taxes, perhaps, the Fed could have continued along its path because no matter how intense the quantitative easing, inflation was not moving.

All that has changed now. Or, at least, the perception of rising wages has taken foot and the bankers aren’t taking any chances. At this point, any event can cause a crash. The market has shown that it is vulnerable; it’s shown its Achilles heel and it can be brought down. Paradoxes will be the norm.

For example, a favorable jobs report—a good thing for millions of Americans who’ve had to struggle for years—is now a bad thing. The big investors and the institutions understood before anyone else what this meant: inflation risk. Thus, they pulled out, causing a domino effect. What’s good for the goose is not always good for the gander. In this situation, Warren Buffett’s advice might be the same he gives his grandchildren when they get into a car: fasten your seatbelts.

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