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Swimming Naked

The global liquidity crisis is still stress-testing the financial system and various institutions around the world continue to disclose one misdeed after another. As liquidity dries up, however, we find out who has been swimming naked, i.e. exposed to risk in a manner well beyond conventional standards. Some of these companies appear to be favored by legendary value investor Warren Buffett, which calls into question the basic assumption on Wall Street, namely that stocks eventually always go up. What if it’s different this time?

We know we are starting a recession, but we may also be at the inception of a new social, political and economic paradigm that will change the face of the world. An Age of Austerity and reduced expectations is likely in the West, but it may have some hidden benefits. We also speculate that the new economic order may be characterized by three billion individual investors seeking yield, not growth.


If you wanted to throw your lot in with the “Oracle of Omaha,” the world’s most watched investor, and decided to buy some Berkshire Hathaway shares last December you could have paid $150,000/share. Buffett has never split the stock, which was trading around $8 in 1962, and does not want to pander to short-term investors/traders. On Thursday (11/13) between 11:15 am and 2:30 pm ET shares of one of the best holding companies in the world could be had for less than $100,000/share, a 33% discount from peak. The shares had not traded at that level for two years.

Buffett has become the poster-person for responsible investing in an irresponsible age. He is also well known for not trying to time the market, but rather for taking advantage of market weakness and irrationality to scoop up shares of good companies at a discount.

Buy American?

On October 17, in the midst of one of the most harrowing months in global financial history, the Oracle made it clear in an Op Ed piece in the NY Times that he was buying the dip in the U.S. market and overweighting domestic shares in his personal portfolio due to the irrational pessimism that had depressed prices. Buffett was putting into practice his famous dictum, “Be fearful when others are greedy and greedy when others are fearful.”

Previously, Buffett had no equities in that portfolio, only bonds, so the switch in asset allocation was doubly underscored. Moreover, Buffett, who once described himself as having been born “wired to allocate capital,” specifically mentioned that he preferred U.S. equities over international names.

Buffett personally, and strict value investors in general, have a well-deserved reputation for being the investors of last resort. It was the implicit endorsement by such a credible and fiscally conservative figure that led Goldman Sachs and General Electric to make well-publicized financing deals with Berkshire. Buffett purchased $5 billion of Goldman’s preferred stock yielding 10%, while paying $125/share. Buffett also bought $3 billion of General Electric’s 10% preferred shares at $22. Goldman has been cut in half since the deal was struck, while GE is off about 50%.

Meanwhile, some of Berkshires largest holdings are also in serious bear markets. The holding company has large positions in American Express (down 65%), CarMax (down 70%), Gannett (down 90%), Moodys (down 60%), and Wellpoint (down 60%). To be fair, Buffett would not consider a 1-month, 1-year or 5-year track record to be a sufficient time period over which to evaluate an investment strategy. For Warren, the current carnage is just emotionally driven noise. He understands Goldman and its franchise after running Solomon Brothers for a few years and we assume he has little doubt about GE’s wide moat and ability to compete effectively in a number of businesses going forward.

Nevertheless, Buffett’s endorsement was not sufficient to guarantee General Electric’s solvency. The company found it necessary to secure the temporary backing of the Federal Deposit Insurance Corp (FDIC) for up to $139 billion due to liabilities in its finance division. Considering that all of GE has a market cap of $168 billion, there is presumed catastrophic risk to the solvency of the company from leveraged financial dealings.

Still, few doubt Buffett’s decision making for the long-term and we respect his value-driven approach. Buying value, even if temporarily unrewarding, is a proven long-term strategy. Buffett once said that his favorite holding period for a stock is “forever,” but that retort is not an absolute mandate. He regrets not selling into the 1990’s bubble and did sell his stake in PetroChina (PTR) after it quintupled.

Swimming Naked

Buffett’s value investing approach is sometimes used to justify a perennially bullish view of the equity market, however. One would-be pundit and Buffett-buff put it thusly, “The key measurement lies in performance comparative to the market. If, over time, you make more than the averages when the market is up and lose less when it is down, you have nothing to worry about long-term.” Really? If there were a dogma on Wall Street, this would be it. Put another way, “In the long run, markets always go up.”

We think it would be prudent to qualify the statement. For starters, we would ask, “Which market?” If you consider the Japanese Nikkei, it has been going down for 18 years. The country has not been in a depression, yet the nation’s stock market has continued to deflate. Adjusted for inflation, gold is about half its 1980 peak. Then there is the Saudi Arabian stock market, which peaked in March of 2006 at around 20,000 and was trading near 10,000 in May of this year when crude had more than doubled to $140/bbl. That does not appear to make much sense, but there it is. A lot goes into making a market and they do not necessarily eventually make higher highs.

The financial seas are churning… and paradigms are shifting along with them. At the very least, the social, political and economic outlook for the next three to five years has been materially altered by the global deleveraging process, which is unwinding the largest credit bubble in the history of the world. As liquidity dries up, we are finding out who has been swimming naked. Bear Stearns was among the first to be exposed, and makes a most suitable example for the metaphor, as the company was embarrassingly bare when it came to liquid assets.

The Coming Age of Austerity

Instead, we believe the market is headed for a period of austerity brought on by new regulatory requirements for increased transparency, accountability and frugality. We are entering a period of reduced expectations both economically and socially. Regulation will operate like a 55 mph speed limit on the economic highway, crimping profits in favor of a more stable economy. As a consumer society, we are not going to be immune from the Great Deleveraging, which is why Treasury Secretary Paulson is planning to allocate some of the Wall Street bailout money directly to Main Street.

As home prices fail to recover, a vast number of middle of the road retailers will go bankrupt, creating a more polarized consumer society than today, with Wal-Mart on one end of the barbell and Tiffany’s on the other. Municipalities will get leaner and public services we once took for granted will be more costly and less frequent or disappear altogether. Postage stamps, refuse collection fees, sales taxes and property taxes will become prohibitively expensive for some citizens. Renting will be preferable to property ownership in many municipalities, further depressing property values.

As the country turns inward to heal its wounds, an isolationist perspective will become dominant, reducing budgets for foreign aid and the military. A populist ethos will dominate the political scene, but credit will be hard to come by. Saving will become “cool,’ cash will be King and equities will be first disparaged and then shunned, as a sustained period of apathy overtakes Wall Street. Established social institutions, from private colleges to philanthropic foundations, will be challenged to survive and many will go extinct as funding dries up.

Unemployed brokers and bankers will enter law school in droves to partake in the Great Litigation process that devolves from the credit debacle, as company after company is held accountable for fraud, misrepresentation and fiduciary malfeasance. Standard & Poors will eventually be discredited and go bankrupt, taking McGraw Hill down with it, and the S&P 500 will be renamed to represent a new Standard for Wall Street. A new era of fixed-income investing will replace hedge-fund driven speculation. Funds will be rated on safety before historical gains are considered, as return of capital trumps return on capital.

And were we to speculate further on social changes, we see some interesting possibilities. For example…

Grass Roots Society

With growing stresses on entitlement programs, dispersed families may reaggregate, as children live with parents longer and grandparents are welcomed back into households as valued contributors to the familial security net. A new appreciation for more cost-effective, wellness and prevention-oriented natural medicine may become necessary to stem the rise of healthcare costs in an aging society.

Micro businesses may flourish as entrepreneurship is focused on local opportunities. Neighbors might know each other again, as a more grassroots economy reestablishes itself. Waste and conspicuous consumption may be less tolerable. Bicycles and scooters could replace cars in many cities, as speed limits are lowered to accommodate a more vulnerable and slower pace of life. Community gardens and farmer’s markets may become social hubs. We might see a greater sharing of local and personal resources rather than an emphasis on individual ownership, which would mirror the socialized institutional investments made by the government in various industries.

As our military is downsized and refocuses away from foreign interventions, soldiers might be deployed in dangerous neighborhoods to protect the citizenry and discourage organized street crime as neighborhoods rebuild. Meanwhile, drug dealing and prostitution might be decriminalized and licensed because the states simply cannot afford to prosecute and house so many criminals.

In Yield We Trust

On the investment horizon we imagine that global growth will resume at some point, but the epicenter will be located in nations other than our own. Fortunately, a 4G worldwide communication network will facilitate asset allocation to any market by any individual with an iPhone or a laptop anywhere on the planet 24/7. CDs denominated in foreign currencies will be commonplace, so individuals will be able to find safety and yield quite easily.

Governments and funds will compete globally on yield, generating massive capital flows from three billion small investors. Fees and commissions on most financial transactions will be nominal or waived entirely to facilitate the flow in a highly competitive environment where deposits and cash assets are highly prized.

For now, we have a rally in the market, as it bounces off the October lows. We once again recommend selling low-yield or non-yield stocks into the strength. We don’t know how long it will last or how far it will run, but we don’t think the bear market is over. Our forecast is for U.S. equity prices to be 40-50% lower in 12 months.

Weekly Publication by The Spear Report www.spearreport.com

About the Author

Since 1995, The Spear Report has published a weekly newsletter that has guided investors with our unique Consensus methodology. We also offer a daily Professional Edition, an Options newsletter, an ETF newsletter, and a Security Industry newsletter.