Buffett’s Optimism Goes On Record; Stocks Go Over

If the world’s savviest investor says U.S. stock prices overall aren’t excessive, shouldn’t that be good enough for the rest of us?

But what if that same investor--the legendary billionaire Warren Buffett--has been selling stocks, on balance, rather than buying?

For Wall Street, the solution to that quandary on Monday was to take what has been the path of least resistance so far this year: Stocks zoomed to record highs, pushing the Dow Jones industrial average up 116.33 points to a record 8,718.85, and boosting its year-to-date gain to 10.3%.

The market was helped by a fresh plunge in crude oil prices, but there was little question among Wall Street pros that Buffett’s soothing words, contained in the annual letter to his shareholders published over the weekend, provided all the impetus some investors needed to take this year’s stunning rally to new heights.

But in a now 7-year-old bull market for which the only valid comparisons may be 1920s Wall Street and late-1980s Japan--both of which ended in financial catastrophe--Buffett did not provide any new insight to help answer the question that gnaws at many investors: How high is too high for stock prices, and are we there yet?

Indeed, the 67-year-old Buffett may only have muddied that debate, because even as he appeared to be justifying the market’s current levels, additional comments he made in the letter--and a record of his actions last year--weren’t nearly so supportive.

Buffett, while hardly infallible in his investment decisions over the last four decades, nonetheless has one of the most successful track records of any living investor. His stake in his investment company, Berkshire Hathaway, is valued at about $27 billion, making him the world’s second-richest individual, after Microsoft Corp.’s Bill Gates.

The passage initially seized upon by the media in Buffett’s annual shareholder letter was his line that “there is no reason to think of stocks as generally overvalued” if interest rates and corporate earnings remain at current levels.

Yet Buffett also disclosed that he reduced his holdings in a number of big-name stocks last year, including McDonald’s Corp., Walt Disney Co. and Wells Fargo & Co.

And Buffett’s major new purchases last year weren’t stocks at all, but long-term Treasury bonds and silver.

“I think it’s perhaps the most self-serving comment in the world” for an investor to say the market isn’t overvalued while he is selling into it, said Charles Crane, chief market strategist at Key Asset Management in New York.

“Bet-A-Billion Buffett Unloads McDog While Wall Street Sleeps,” wrote money manager and long-time Buffett-watcher Bill Mason of Cullen, Fortier Asset Management in Woodland Hills, in a letter Monday to clients.

That the level of suspicion about the normally venerated Buffett’s comments should be so high is a reflection of many Wall Street pros’ growing fear that the ongoing stock rally has become a monster, an out-of-control creation of rabid investor optimism that can’t end any way but badly--as did the 1920s boom, and Japan’s wild stock rally in 1988 and 1989.

But even though the Dow average has risen 127% just since 1994--a return far above the normal historical return on stocks of about 10.5% a year--other analysts see the market’s continuing advance as supported by solid underpinnings: declining interest rates, extraordinarily low inflation, a still-healthy U.S. economy, and--perhaps most significant--a Federal Reserve Board that is pumping up the nation’s financial system with fresh cash, and lots of it.

Yet even most of the bulls admit they have been surprised by the power in this year’s rally, after three consecutive years of 20%-plus gains in the Dow index--a streak that occurred only once before, from 1933 to 1935, as stocks were rebounding from the crash that began in 1929.

At the start of this year, another gain in the market seemed extremely unlikely, at least in the near term. Asia’s financial debacle was worsening, which was expected to translate into weaker U.S. economic growth and corporate earnings, undercutting stock values.

Then the newest wave of sexual-impropriety allegations against President Clinton surfaced, threatening foreign investors’ confidence in U.S. leadership and markets.

And all along, individual investors have appeared to be taking a much more cautious tack toward the market. Although billions of dollars have still flowed into stock mutual funds every week, inflows have been well below last year’s peaks. Many investors have instead been funneling money into bond mutual funds, a significantly lower-risk investment than stocks. Since summer, bond fund purchases have been running at the highest pace since 1993.

Yet by late January, the stock market was racing upward again. At current levels, the Dow need rise less than 15% to break the 10,000 level.

What has happened, analysts say, is simply that what many veteran Wall Streeters have dubbed “the luckiest market on Earth” got even luckier, and share prices have risen to reflect that:

* Amid a glut of supply worldwide, crude oil prices have collapsed to nine-year lows, effectively providing a huge tax cut for American consumers and businesses.

* Inflation overall also has remained low, thanks in part to the benefit of cheaper goods coming from Asia’s economies. Low inflation, in turn, has allowed long-term U.S. interest rates to fall to near 20-year lows.

* Asia’s financial crisis has at least stabilized, which has allowed stock markets across the region to rally from their depths.

* In Europe, key economies have shown surprising strength so far this year, helping the global economy to offset some of the negative effects of Asia’s downturn.

Most important, however, has been the amazing resilience of the U.S. economy. Boosted by healthy job creation, low interest rates and a warm winter that has kept housing sales and retail sales humming, the United States has so far appeared to suffer incredibly little damage from the Asian financial disaster.

In the face of such good news, the bigger surprise would have been if stocks had not rallied, many experts insist.

“The fundamentals for the stock market are as good as they have ever been,” said William Dudley, economist at brokerage Goldman, Sachs & Co. in New York.

But as stocks have climbed ever higher, they are setting records in more than just absolute terms. Relative to companies’ underlying earnings per share, and underlying assets--the ultimate underpinning for equity prices--stocks are at levels either rarely seen in history, or never seen before.

That is what has puzzled some Buffett disciples regarding his comments in his shareholder letter. Buffett is considered the ultimate “value” investor, someone who abhors overpaying for stocks, even great stocks.

Why, then, with stock prices so high versus underlying earnings and asset values, would Buffett say the market isn’t overvalued?

Buffett said he is judging stocks’ valuations relative to two important variables: Interest rates on fixed-income securities (which compete with stocks as investments) and companies’ ability to sustain strong earnings growth and a high return on their shareholders’ capital.

“At the annual meeting last year,” Buffett wrote in the letter published Saturday, “with the Dow at 7,071 and long-term Treasury yields at 6.89% . . . I stated that we did not consider the market overvalued if 1) interest rates remained where they were or fell, and 2) American business continued to earn the remarkable returns on equity that it had recently recorded.

“So far, interest rates have fallen--that’s one requisite satisfied--and returns on equity still remain exceptionally high. If they stay there--and if interest rates hold near recent levels--there is no reason to think of stocks as generally overvalued,” he said.

But he also added: “On the other hand, returns on equity are not a sure thing to remain at, or even near, their present levels.”

That is the clincher, worried market analysts say: A rising number of major U.S. companies, including Intel, Sears, IBM and Nike, have already warned that first-quarter earnings will be lower than expected.

Earnings are under pressure from weakness in Asian operations, rising U.S. wage rates and an inability on the part of most companies to raise prices in an extremely competitive global economy.

Indeed, analysts now expect U.S. blue-chip companies overall to post earnings growth of less than 3% this quarter, versus a year earlier. That is a dramatic deceleration from the double-digit earnings growth of recent years.

Does that mean corporate America is entering a phase in which earnings might actually decline?

So far, most of Wall Street believes that although companies’ earnings will slow this year, there will still be some growth. Whether there will be enough growth to justify current stock prices, however, is the open question.

For now, the majority of investors appear to be in the camp Buffett professes to be in: the one that gives stocks the benefit of the doubt, even after seven years of tremendous gains.

“People have raised their valuations for stocks [the prices they’re willing to pay], and they will continue to raise them until they have a reason not to,” said John Williams, economist at Bankers Trust Co. in New York.

He noted that although the Federal Reserve Board has kept short-term interest rates at levels that some economists view as constituting “tight credit,” the Fed has in fact allowed the nation’s money supply to expand substantially over the last six months.

European central banks, and Japan’s central bank, have done the same. In essence, the banks are providing enormous liquidity to the global financial system--a reaction, it appears, to worries about the system’s health in the wake of Asia’s economic turmoil.

That liquidity, in turn, is finding its way from the banking system “into the real economy and into the stock market,” said money manager Crane.

Even if many individual investors have been more reticent about buying stock mutual funds at the market’s current level, Crane noted that, for competitive reasons, portfolio managers themselves feel they have little choice but to pile into the market as it rushes higher, regardless of stocks’ valuations.

The managers’ fear, Crane said, is of being left behind should prices go far beyond today’s levels.

Buying is easier than selling, he said, “Because most money managers have regretted every sale they’ve made in recent years--my own experience included.”

What many stock investors don’t want to think about, Crane argues, is what will happen when the central banks--in particular, the Fed--decide that the global economy is again on solid enough footing to justify making money more expensive, via higher rates.

That is Buffett’s other concern in his market-valuation equation, although the billionaire doesn’t try to predict the Fed, or interest rates in general. And most economists believe the Fed is months away from even considering a rate increase, if one occurs at all.

In the meantime, Crane suggests that investors weigh what Buffett said--his positive overall tone about stocks--against what he did, which was be a net seller last year, not a buyer.

* BROAD ADVANCE: Stocks post strong gains as oil prices plunge. D19

* BUFFETT SPEAKS: Excerpts from Warren Buffett’s shareholder letter. D7