Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2013 by Carol J. Loomis

Author:Carol J. Loomis [Loomis, Carol J.]
Language: eng
Format: azw3
ISBN: 9781101601501
Publisher: Penguin Publishing Group
Published: 2012-11-21T05:00:00+00:00

DOW JONES INDUSTRIAL AVERAGE

Dec. 31, 1964: 874.12

Dec. 31, 1981: 875.00

Now I’m known as a long-term investor and a patient guy, but that is not my idea of a big move.

And here’s a major and very opposite fact: During that same 17 years, the GDP of the U.S.—that is, the business being done in this country—almost quintupled, rising by 370%. Or, if we look at another measure, the sales of the Fortune 500 (a changing mix of companies, of course) more than sextupled. And yet the Dow went exactly nowhere.

To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point—by 0.01%—the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect—like the invisible pull of gravity—is constantly there.

In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there—in that tripling of the gravitational pull of interest rates—lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.

Then, in the early 1980s, the situation reversed itself. You will remember Paul Volcker coming in as chairman of the Fed and remember also how unpopular he was. But the heroic things he did—his taking a two-by-four to the economy and breaking the back of inflation—caused the interest rate trend to reverse, with some rather spectacular results. Let’s say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every time you got an interest payment, you used it to buy more of that same bond. At the end of 1998,

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