Warren Buffett's Berkshire Hathaway Inc. announced its holdings last week, with its cash reserves reaching a new high. However, a large amount of capital has recently been flowing into the leveraged market, raising the question of whether this rally will form the final stage of an irrational prosperity. What implications does Buffett's cash level give us?
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ToggleBuffett's indicator has been at a high level for a long time, and the cash position has reached a new high
The 94-year-old Buffett remains cautious about investing capital. At Berkshire's annual shareholder meeting in May, he expressed his investment willingness, but also emphasized that it is not easy to find attractive investment opportunities.
In a Forbes interview in December 2001, Buffett mentioned that the ratio of the total market value to GDP can be used to judge whether the overall stock market is overvalued or undervalued, which is commonly known as the Buffett indicator. This indicator can measure whether the current financial market reasonably reflects the fundamentals. Buffett's theoretical index indicates that a range of 75% to 90% is reasonable, and above 120% indicates that the stock market is overvalued. According to the chart from Financial M Square, the Buffett indicator has been at a high level since 2016, and the current value is 205%.
Berkshire's cash reserves reached $325.2 billion in the third quarter, and for the first time since the second quarter of 2018, the company did not repurchase its own shares. This cash reserve is nearly twice the company's year-end cash balance, and is the largest cash reserve Buffett has ever accumulated.
The relationship between Berkshire's cash position and the market
According to Bloomberg, Berkshire's cash allocation as a percentage of the company's assets has varied greatly over the years, from 1% in 1994 to nearly 28% now, and various situations in between. The record shows that as stock valuations have risen during prosperous periods, Buffett has continuously increased Berkshire's cash allocation, resulting in a decline in expected returns, and reduced cash when opportunities arose.
For example, during the internet bubble in the late 1990s, as valuations rose, Buffett increased the cash allocation from 1% of assets four years earlier to 13% in 1998. But he reduced the cash allocation to 3% in 1999 (about a year before the bubble burst), probably because he found an attractive target. In hindsight, he might have done better to hold that cash for another year when bargains became plentiful, but even the great Buffett couldn't see the change coming. However, he did one good thing, which was to use almost all of Berkshire's cash during the economic downturn.
Then he turned again before the 2008 financial crisis. After the market recovery in 2002, Buffett began to significantly increase the cash allocation, reaching 25% of assets by 2005. But when the impending crisis caused stock prices to plummet from the end of 2007, Buffett used his cash, and ultimately reduced the cash allocation to 7% of assets by 2010, partly due to his savvy investment in Goldman Sachs Group Inc.
Bloomberg Opinion columnist Nir Kaissar believes that Buffett is betting on a simple principle: valuation and future returns are inversely related. That is, when assets are expensive, future returns are often lower, and vice versa.
The forward price-earnings ratio of the S&P 500 index is approaching a historical high
Major fund management companies, including BlackRock, Vanguard, Goldman Sachs, and JPMorgan, all expect the future U.S. stock market returns to be far lower than the historical annual return of 9% over the past 150 years.
The current forward price-earnings ratio of the S&P 500 index is 25 times, approaching the historical high, while the average price-earnings ratio since 1990 has been 18 times.
Experts calculate that the expected return on the S&P 500 index over the next 10 years is around 4%, not much different from the 4.4% yield on 3-month Treasury bills. Berkshire's increase in cash reserves (mostly short-term Treasuries) to strengthen its precautionary allocation is not surprising.
A large amount of capital has flowed into the leveraged market
On the other hand, on the fringes of Wall Street, the frenzy of speculation is growing. This includes MicroStrategy, which calls itself a Bit development company, and related high-risk leveraged ETFs, which had a trading volume of $86 billion this week, a new high. MicroStrategy's stock price rose 24% in a single week, and two leverage funds based on the company had a total inflow of $420 million.
(MicroStrategy's stock premium over Bit reaches 256%, falls 16% after Citron goes short)
Matt Tuttle, CEO of Tuttle Capital Management, which operates one of the funds, said he bought a series of MicroStrategy stocks through leveraged ETFs this week. His market makers had to buy more stocks to hedge their positions. "Look at all the retail investors buying MicroStrategy options - constantly, constantly, constantly buying. This could get really crazy."
Daniel Kirsch, head of options at Piper Sandler, said that the daily rebalancing of leveraged ETFs, whether it's a leveraged ETF or the return of a single stock, can potentially increase the volatility of the underlying asset, especially when daily fluctuations are large.
Of course, leverage and investors' general FOMO may hurt the bulls, just as it has recently helped them chase risky assets. Currently, there are no signs that investors are ready to reduce their exposure to risky assets.
But will this rally form the final leg of an irrational exuberance? What does Buffett's cash position tell us? It's worth readers' careful observation and reflection.
