Warren Buffett still likes the stock market, and the reason why lies with the bond market.
“[Stock] valuations make sense with interest rates where they are,” Buffett said in an interview on CNBC’s Squawk Box on Tuesday. “In the end, you measure laying out money for an asset in relation to what you’re going to get back, and the number one yardstick is U.S. government [bonds].”
Buffett noted that these comments echo what he’s said previously on the subject, including to Yahoo Finance editor-in-chief Andy Serwer back in April.
“Everything in valuation gets back to interest rates,” Buffett told Serwer.
The basic concept that Buffett is speaking to is the idea of a hurdle rate, or what the lowest acceptable return would be on your money. Given that U.S. Treasury bonds are considered by markets to be entirely safe, Buffett is using this rate as essentially a replacement for cash — if he had nothing else to do with his money he’d dump it all into Treasuries and earn about 2.5% over the next decade plus.
In recent weeks, the yield on U.S. Treasury bonds has increased some, with the 10-year sitting near 2.35% and the 30-year sitting just below 2.9%. Shorter-term yields have also moved up over the last couple year as the Federal Reserve has begun raising its benchmark interest rate, with the 2-year yield currently near its highest level since 2008. Even so, yields across the Treasury complex remain quite low relative to history.
And this is why Buffett has said that if he could only know one thing about the future, he would not ask about GDP growth or who the president was, but what the 10-year Treasury yield would be. The math here is simple — if interest rates go higher, the stock market’s valuation comes under more pressure to justify itself relative to the risk-free rate one can earn in Treasuries.
Right now, the price-to-earnings ratio for the market, a rough measure of how much one needs to pay to earn $1 in profit, is around 25, higher than it’s been for most of history yet below peaks seen near the tech bubble. Interest rates, however, are also near generational lows despite calls for the 40-year bond bull market — bond prices rise when yields fall — to end.
“I don’t try to guess the stock market,” Buffett said Tuesday. “But if I were to guess, if the 10-year [yield] moved up to 5% I think stocks would be somewhat cheaper.” (Meaning stock prices would likely come down.)
Buffett added, however, that while the Federal Reserve has stated its intention to move interest rates higher through time, the Fed itself doesn’t know where rates will be in three years.
“If in three years from now interest rates are 1%, stocks will look cheap at these prices,” Buffett said. “If they move up to 4%, they won’t look cheap.”
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Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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