I do not believe that anticipating stock market fluctuations is on the whole a satisfactory activity. The work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years. (For example, Jim Cramer and Abby Joseph Cohen have been less reliable than the tossing of a coin.)

It is possible to know when stocks as a group are too high or too low. This can help investors determine what percentage of capital to deploy in arbitrage operations, which are insulated from market fluctuations, as opposed to generally undervalued securities.

On page 7 of Security Analysis (Fourth Edition), Benjamin Graham discusses an important variable in market valuation:

“The relationship of business earnings and GNP is a factor which merits careful consideration by the analyst. There are some weaknesses in the statistics across the 52-year span, but it is doubtful that they are sufficient to destroy perspective. Examination of the data shows that for the entire period from 1909 through 1960, corporate earnings averaged 5.3 percent of GNP.”

There is a remarkably consistent relationship between the market value of goods produced by American enterprise and its after-tax profits. The 5.3 percent average has risen only slightly since 1960—to about 6. Unless there is a change in earnings multipliers, therefore, stock prices should advance at the same rate as GDP—about 3% in real terms; 5% nominally.

In 2007 after-tax corporate profits as a percentage of GDP amounted to 8%—an historically high level ($1,128.6 billion / 14,074.2 billion: Bureau of Economic Analysis). At the same time, risk-free interest rates are below long term averages and S&P valuation multiples are slightly above. Were all three variables to revert to historical norms, one would logically expect future stock returns to be mediocre; stocks appear somewhat expensive.

Warren Buffett discussed market valuation in 1999 as well as in 1969:

Finally, a word about expectations. A decade or so ago I was quite willing to set a target of ten percentage points per annum better than the Dow, with the expectation that the Dow would average about 7%. This meant an expectancy for us of around 17%—with wide variations and no guarantees, of course—but, nevertheless, an expectancy. Tax-free bonds at the time yielded about 3%. While stocks had the disadvantage of irregular performance, overall they seemed much the more desirable option. I also stressed this preference for stocks in teaching classes, participating in panel discussions, etc.

For the first time in my investment lifetime, I now believe there is little choice for the average investor between professionally managed money in stocks and passive investment in bonds. If correct, this view has important implications. Let me briefly (and in somewhat over-simplified form) set out the situation as I see it:

(1) I am talking about the situation for, say, a taxpayer in a 40% Federal Income Tax bracket who also has some State Income Tax to pay. Various changes are being proposed in the tax laws, which may adversely affect net results from presently tax-exempt income, capital gains, and perhaps other types of investment income. More proposals will probably come in the future. Overall, I feel such changes over the years will not negate my relative expectations about after-tax income from presently tax-free bonds versus common stocks, and may well even mildly reinforce them.

(2) I am talking about expectations over the next ten years—not the next weeks or months. I find it much easier to think about what should develop over a relatively long period of time than what is likely in any short period. As Ben Graham said: “In the long run, the market is a weighing machine—in the short run, a voting machine.” I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology.

(3) Purely passive investment in tax-free bonds will now bring about 6 ½%. This yield can be achieved with excellent quality and locked up for just about any period for which the investor wishes to contract. Such conditions may not exist in March when Bill and I will be available to assist you in bond purchases, but they exist today.

(4) The ten year expectation for corporate stocks as a group is probably not better than 9% overall, say 3% dividends and 6% gain in value. I would doubt that Gross National Product grows more than 6% per annum—I don’t believe corporate profits are likely to grow significantly as a percentage of GNP—and if earnings multipliers don’t change (and with these assumptions and present interest rates they shouldn’t) the aggregate valuation of American corporate enterprise should not grow at a long-term compounded rate above 6% per annum. This typical experience in stocks might produce (for the taxpayer described earlier) 1 ¾% after tax from dividends and 4 ¾% after tax from capital gain; for a total after-tax return of about 6 ½%. The pre-tax mix between dividends and capital gains might be more like 4% and 5%, giving a slightly lower after-tax result. This is not far from historical experience and, overall, I believe future tax rules on capital gains are likely to be stiffer than in the past.

(5) Finally, probably half the money invested in stocks over the next decade will be professionally managed. Thus, by definition virtually, the total investor experience with professionally managed money will be average results (or 6 ½% after tax if my assumptions above are correct).

My judgment would be that less than 10% of professionally managed money (which might imply an average of $40 billion just for this superior segment) handled consistently for the decade would average 2 points per annum over group expectancy. So-called “aggressively run” money is unlikely to do significantly better than the general run of professionally managed money. There is probably $50 billion in various gradations of this “aggressive” category now—maybe 100 times that of a decade ago—and $50 billion just can’t “perform.”

If you are extremely fortunate and select advisors who achieve results in the top 1% to 2% of the country (but who will be working with material sums of money because they are that good), I think it is unlikely you will do much more than 4 points per annum better than the group expectancy. I think the odds are good that Bill Ruane is in this select category. My estimate, therefore, is that over the next decade the results of really excellent management for our “typical taxpayer” after tax might be 1 ¾% from dividends and 7 ¾% from capital gain, or 9 ½% overall.

(6) The rather startling conclusion is that under today’s historically unusual conditions, passive investment in tax-free bonds is likely to be fully the equivalent of expectations from professionally managed money in stocks, and only modestly inferior to extremely well-managed equity money.