Warren Buffett, chairman of Berkshire Hathaway, almost never talks publicly about the general level of stock prices. But in the past few months, on four occasions Buffett did step up to that subject, laying out his opinions about the long-term future for US stocks. Fortune's Carol Loomis distilled the following account from his talks. 

Investors in stocks these days are expecting far too much, and I'm going to explain why. 

That will inevitably set me to talking about the general stockmarket, a subject I'm usually unwilling to discuss, but I want to make one thing clear going in: though I will be talking about the level of the market, I will not be predicting its next moves. 

At Berkshire, we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it's going to go next week or next month or next year, a line of thought we never get into. 

The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. 

Sooner or later, though, value counts. So what I am going to be saying assuming it's correct will have implications for long-term results. Now, to get some historical perspective, let's look back at the 34 years before this one and here we are going to see an almost biblical kind of symmetry in the sense of lean years and fat years to observe what happened in the stockmarket. 

Take the first 17 years of the period, from the end of 1964 through to 1981. Here's what took place in that interval: the Dow Jones Industrial Average at December 31, 1964, was 874.12, at December 31, 1981, it was 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 US that is, the business being done in this country almost quintupled, rising by 370 per cent. 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 per cent 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 per cent at year-end of 1964 to more than 15 per cent 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 stockmarket 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 $US1 million into the 14 per cent 30-year US bond issued November 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, with long-term governments selling at 5 per cent, you would have had $US8,181,219 and would have earned an annual return of more than 13 per cent. 
That 13 per cent annual return is better than stocks have done in a great many 17-year periods in history in most 17-year periods, in fact. It was a helluva result, and from none other than a stodgy bond. 

The power of interest rates had the effect of pushing up equities as well, though other things that we will get to pushed additionally. And so here's what equities did in that same 17 years: if you'd invested $US1 million in the Dow on November 16, 1981, and reinvested all dividends, you'd have had $US19,720,112 on December 31, 1998. And your annual return would have been 19 per cent. 

The increase in equity values since 1981 beats anything you can find in history. This increase even surpasses what you would have realised if you'd bought stocks in 1932 at their Depression bottom on its lowest day, July 8, 1932, the Dow closed at 41.22 and held them for 17 years. 

The second thing bearing on stock prices during this 17 years was after-tax corporate profits as a percentage of GDP. Corporate profits as a percentage of GDP peaked in 1929 and then they tanked. But from 1951 on, the percentage settled down to a 4 per cent to 6.5 per cent range. 

By 1981, though, the trend was headed towards the bottom of that band, and in 1982 profits tumbled to 3.5 per cent. So, at that point investors were looking at two strong negatives: profits were sub-par and interest rates were sky-high. And as is so typical, investors projected out into the future what they were seeing. That's their unshakable habit: looking into the rear-view mirror instead of through the windshield. What they were observing, looking backwards, made them very discouraged about the country. They were projecting high interest rates, they were projecting low profits, and they were therefore valuing the Dow at a level that was the same as 17 years earlier, even though GDP had nearly quintupled. 

Now, what happened in the 17 years beginning with 1982? One thing that didn't happen was comparable growth in GDP: in this second 17-year period, GDP less than tripled. But interest rates began their descent and, after the Volcker effect wore off, profits began to climb not steadily, but nonetheless with real power.

By the late 1990s after-tax profits as a per cent of GDP were running close to 6 per cent, which is on the upper part of the "normalcy" band. And, at the end of 1998, long-term government interest rates had made their way down to that 5 per cent level. 
These dramatic changes in the two fundamentals that matter most to investors explain much, though not all, of the more than tenfold rise in equity prices the Dow went from 875 to 9,181 during this 17-year period. 

What was at work also, of course, was market psychology. Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. 

In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov's dog, these "investors" learn that when the bell rings in this case, the one that opens the New York Stock Exchange at 9:30am they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich. Today, staring fixedly back at the road they just travelled, most investors have rosy expectations. A Paine Webber and Gallup Organisation survey released in July shows that the least experienced investors those who have invested for less than five years expect annual returns over the next 10 years of 22.6 per cent. Even those who have invested for more than 20 years are expecting 12.9 per cent. 

Now, I'd like to argue that we can't come even remotely close to that 12.9 per cent and make my case by examining the key value-determining factors. Today, if an investor is to achieve juicy profits in the market over 10 years, or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two: Interest rates must fall further. If [US] government interest rates, now at a level of about 6 per cent, were to fall to 3 per cent, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that or fall to the 1 per cent that Japan experienced you should head for where you can really make a bundle: bond options.

Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. 

When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percentage of GDP can, for any sustained period, hold much above 6 per cent. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: if corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems and in my view a major reslicing of the pie just isn't going to happen. 

So where do some reasonable assumptions lead us? Let's say that GDP grows at an average 5 per cent a year 3 per cent real growth, which is pretty darn good, plus 2 per cent inflation. If GDP grows at 5 per cent, and you don't have some help from interest rates, the aggregate value of equities is not going to grow a whole lot more. Yes, you can add on a bit of return from dividends. But with stocks selling where they are today, the importance of dividends to total return is way down from what it used to be. 

Nor can investors expect to score because companies are busy boosting their per-share earnings by buying in their stock. The offset here is that the companies are just about as busy issuing new stock, both through primary offerings and those ever-present stock options. 

So I come back to my postulation of 5 per cent growth in GDP and remind you that it is a limiting factor in the returns you're going to get: you cannot expect to forever realise a 12 per cent annual increase much less 22 per cent in the valuation of American business if its profitability is growing only at 5 per cent. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do. 
Now, maybe you'd like to argue a different case. Fair enough. But give me your assumptions. If you think the American public is going to make 12 per cent a year in stocks, I think you have to say, for example: "Well, that's because I expect GDP to grow at 10 per cent a year, dividends to add two percentage points to returns and interest rates to stay at a constant level." Or you've got to rearrange these key variables in some other manner. The Tinker Bell approach clap if you believe just won't cut it. 

Beyond that, you need to remember that future returns are always affected by current valuations and give some thought to what you're getting for your money in the stockmarket right now. Here are two 1998 figures for the Fortune 500. The companies in this universe account for about 75 per cent of the value of all publicly-owned American businesses, so when you look at the 500, you're really talking about America Inc. 

For Fortune 500 companies, the 1998 profits collectively were $US334,335,000,000. And the market value on March 15, 1999, was $US9,907,233,000,000. 

As we focus on those two numbers, we need to be aware that the profits figure has its quirks. Profits in 1998 included one very unusual item a $US16 billion bookkeeping gain that Ford reported from its spin-off of Associates and profits also included, as they always do in the 500, the earnings of a few mutual companies, such as State Farm, that do not have a market value. Additionally, one major corporate expense, stock-option compensation costs, is not deducted from profits. On the other hand, the profits figure has been reduced in some cases by write-offs that probably didn't reflect economic reality and could just as well be added back in. But leaving aside these qualifications, investors were saying on March 15 this year that they would pay a hefty $US10 trillion for the $US334 billion in profits. Bear in mind this is a critical fact often ignored that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices. Let's say the Fortune 500 was just one business and that the people in this room each owned a piece of it. In that case, we could sit here and sell each other pieces at ever-ascending prices. You personally might outsmart the next fellow by buying low and selling high. But no money would leave the game when that happened: you'd simply take out what he put in. Meanwhile, the experience of the group wouldn't have been affected a whit, because its fate would still be tied to profits. 

And there's still another major qualification to be considered. If you and I were trading pieces of our business in this room, we could escape transactional costs because there would be no brokers around to take a bite out of every trade we made. But in the real world investors have a habit of wanting to change chairs, or of at least getting advice as to whether they should, and that costs money big money. 

And don't brush these expenses off as irrelevancies. If you were evaluating a piece of investment real estate, would you not deduct management costs in figuring your return? Yes, of course and in exactly the same way, stockmarket investors who are figuring their returns must face up to the frictional costs they bear. 

And what do they come to? My estimate is that investors in American stocks pay out well over $US100 billion a year say, $US130 billion to move around on those chairs or to buy advice as to whether they should! Perhaps $US100 billion of that relates to the Fortune 500. In other words, investors are dissipating almost a third of everything that the Fortune 500 is earning for them that $US334 billion in 1998 by handing it over to various types of chair-changing and chair-advisory "helpers". 

Perhaps by now you're mentally quarrelling with my estimate that $US100 billion flows to those "helpers". 

Let me count the ways. Start with transaction costs, including commissions, the market maker's take, and the spread on underwritten offerings. 

I would estimate that the transaction cost per share for each side that is, for both the buyer and the seller this year will average 6¢. That adds up to $US42 billion. 

Move on to the additional costs: hefty charges for little guys who have wrap accounts; management fees for big guys; and, looming very large, a raft of expenses for the holders of domestic equity mutual funds. These funds now have assets of about $US3.5 trillion, and you have to conclude that the annual cost of these to their investors counting, for example, management fees, sales loads, general operating costs runs to at least 1 per cent, or$US35 billion. 

In short, $US100 billion of costs for the owners of the Fortune 500 which is 1 per cent of the 500's market value looks to me highly defensible as an estimate. 

I heard once about a cartoon in which a news commentator says: "There was no trading on the New York Stock Exchange today. Everyone was happy with what they owned." Well, if that were the case, investors would every year keep around $US130 billion in their pockets. 

Let me summarise what I've been saying about the stockmarket: I think it's very hard to come up with a persuasive case that equities will, over the next 17 years perform anything like anything like they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate repeat, aggregate would earn in a world of constant interest rates, 2 per cent inflation, and those ever-hurtful frictional costs, it would be 6 per cent. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4 per cent in real terms. And if 4 per cent is wrong, I believe that the percentage is just as likely to be less as more. 

Let me come back to what I said earlier: that there are three things that might allow investors to realise significant profits in the market going forward. The first was that interest rates might fall, and the second was that corporate profits as a per cent of GDP might rise dramatically. The third point: Perhaps you are an optimist who believes that though investors as a whole may slog along, you yourself will be a winner. That thought might be particularly seductive in these early days of the information revolution (which I wholeheartedly believe in) just pick the obvious winners, your broker will tell you, and ride the wave. 

Well, I thought it would be instructive to go back and look at a couple of industries that transformed the US much earlier in this century: automobiles and aviation. Take automobiles: I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. All told, there appear to have been at least 2,000 car makers, in an industry that had an incredible impact on people's lives. If you had foreseen in the early days of cars how this industry would develop, you would have said: "Here is the road to riches." So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three US car companies themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America and also an enormous impact, though not the anticipated one, on investors. 

Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the car when it came along, but still found it hard to pick companies that would make you money. 

The other truly transforming business invention of the first quarter of the century, besides the car, was the aeroplane another industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft manufacturers and found that in the 1919-39 period there were about 300 companies: only a handful are still breathing today. And failures: 129 airlines in the past 20 years filed for bankruptcy. 

As of 1992, in fact though the picture would have improved since then the money made since the dawn of aviation by all of this country's airline companies is zero. 

Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough I owed this to future capitalists to shoot him down. 

I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did. 
I won't dwell on other glamorous businesses that dramatically changed our lives. But I will draw a lesson from these businesses: the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. 

The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. 

This talk of 17 year periods makes me think incongruously, I admit of 17 year locusts. What could a current brood of these critters, scheduled to take flight in 2016, expect to encounter? I see them entering a world in which the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment but only because they expected too much. 

Grumpy or not, they will have by then grown considerably wealthier, simply because the American business establishment that they own will have been chugging along, increasing its profits by 3 per cent annually in real terms. Best of all, the rewards from this creation of wealth will have flowed through to Americans in general, who will be enjoying a far higher standard of living than they do today. Not a bad world at all even if it doesn't measure up to what investors got used to in the 17 years just passed. 

Carol Loomis writes for Fortune magazine