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On December 31, 1964 the Dow closed at 874.2.  Seventeen Years later on December 31, 1981 the Dow closed at 875.  Over that time period the GDP of the US grew by 370%, the sales of the Fortune 500 more than sextupled, and the Dow inched up a mere fraction of a point.

How is it possible that the economy could expand by such a large degree when the Dow grew by only one tenth of a percent?  This is the question that Warren Buffett posed in a 1999 interview in Fortune magazine on the nature of the current market.  The simple answer is that the value of the economy grew but the price investors were willing to pay for a share of the future of that economy did not.  So the actual question is what caused investors to have such a low valuation of the economy despite its huge growth.  It is important to remember the simple, often forgotten, idea behind investment which Buffett defines as, “laying out money today to receive more money tomorrow.”  In effect the value of an investment is the expected return and a decline in investor valuation signals a decline in expected returns.  Thus, the answer to the question put forth by Buffet can be found by looking at the value of expected returns.

The career of Wade Dokken began at a historic low valuation in the market, and everyone whose career had an early 1980’s beginning has experienced an unprecedented market run.   We formed WealthVest Marketing to market guaranteed annuities, index annuities, and income annuities—because we believe that we may be in another period—not unlike the 1964-1982 period—and a period unknown to almost all current financial service professionals.   So, this is a story of stock market valuation—and over-valuation.

Every asset has some level of uncertainty attached to its future value.  This uncertainty is quantified by risk which effectively lowers the future value of an asset.  Investors need to compare this risk between multiple assets and, as a result, for any meaningful comparisons to be made there has to be some kind of standard of risk to be compared to.  This comes in the form of what is called the risk free rate which is derived from the interest rates on long term government bonds, an asset with effectively no risk.  This is the baseline value to which all investments are ultimately compared to.  Even minor changes in these interest rates can have huge effects on market valuation.  Buffett underlines the far reaching nature of these rates by saying, “In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates, changes the value of every financial asset.”  Overall, the risk free rate is the first thing an investor looks at when trying to determine how much he should pay for even one dollar in the future.

 

This graph is a perfect example of how changing interest rates can have a huge impact on the markets.  As the risk free rate rises it lowers the value of other assets because of the inherent risk associated with them.  It comes down to the idea that if two assets have identical rates of return but differing levels of risk, then the asset with lower risk will always be more valuable.  In the case of an asset with effectively zero risk, a small increase in the interest rate can significantly depreciate even the value of assets with much higher rates of return.  Conversely, a drop in the risk free rate can significantly inflate the value of an asset (in my opinion this is the dominant risk today—and why we are structuring innovative index annuities, which fundamentally reduce inherent investment risk).    This is the first part of the explanation as to why the stock market preformed so poorly in the period from the mid 60’s to the early 80’s.  Interest rates steadily increased threefold from 1964 to 1981 where they finally peaked at 15.32%, a level which is almost unfathomable today.  This served to suppress the relative value of assets during this period despite significant gains in the economy.