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By Matthew Coffina, CFA and Jeremy Glaser | 05-02-2015 12:00 PM

Buffett: Interest Rates Key to Understanding Stock Valuation

In our mid-meeting update, Morningstar's Matt Coffina discusses Buffett's view of stock valuations, cost-cutting, and more.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Matt Coffina--he is the editor of Morningstar StockInvestor newsletter. We're at the midway point of the Berkshire Hathaway meeting. We're going to get his take on that first half.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So, one of the most interesting discussions that Buffett had was about stock valuation and how it relates to interest rates. He said that stocks do seem to be pretty fully valued or to have high valuations, but that that might be justified with rates. What did you think of this discussion and what do you think about stock valuations?

Coffina: So, one metric that Buffett has brought up in the past is the ratio of the total stock market value to the gross domestic product of the United States, and that's definitely at the high end of its historical range. I think if you look at a variety of other measures like Shiller P/E or the price to trailing peak operating earnings, we get a similar story; the S&P is trading at a relatively rich valuation, but Buffett really emphasized the point that it all depends on interest rates.

Interest rates remain very low by historical standards. If you are comparing the expected returns from stocks against the expected returns from other asset classes like bonds, stocks still look very attractive. And so, I think you are in a situation where if interest rates stay as low as they are, stocks could still be very cheap and there could still be additional upside. And if we go back to a normal interest-rate environment, then stocks are probably more on the expensive side. And they didn't really give a clear answer as to that. They basically said it's up to you--do you think interest rates are sustainable here or not? And if interest rates are going higher, then in all likelihood, stocks are fully valued to overvalued.

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