Buy the company,
not the market
Before we get
down to business and start talking about whats going on with the market
and what you should do with your money now lets just remind
ourselves that its all pointless anyhow, and that according to the greatest
investment gurus of all time, successful market timing is impossible.
ask if the market is going to go up or down next year. I know there is nobody
who can tell me that". John Templeton
long felt that the only value of stock forecasters is to make fortune tellers
look good. Even now, Charlie and I continue to believe that short-term market
forecasts are poison and should be kept locked up in a safe place, away from
children and also from grown-ups who behave in the market like children".
I have noticed anything over these 60 years on Wall Street, it is that people
do not succeed in forecasting whats going to happen to the stockmarket".
weve been banging on about for two years. Invest in quality companies
for the long term and dont try to pick the peaks and troughs of the
Which is all
well and good, but what if you happen to buy at the start of a two-year bear
market caused by, just for instance, a credit crunch that has nothing to do
with the companies and their management, and only to do with lending $US1
trillion to poor people in the United States who want to stop renting but
cant actually repay the loans theyve now taken on board and whose
houses are now worth less than the value of the loans?
So you do the
right thing and buy shares in a great company but it takes three years to
get back to the price you paid because something else happened, entirely unrelated
to that company.
timing doesnt matter except when it does.
has been making fun of all the intermediaries he calls helpers
over the past couple of years, taking aim in his last couple of letters to
Berkshire Hathaway shareholders at the investment bankers and hedge funds
that are skimming a lot of money from the ultimate owners of companies with
all their helping.
not a joke any more. Things have got to the point where the games of hedge
funds and all the other creations of investment bankers have fundamentally
changed the way the financial markets operate.
Prices are jumping
around for reasons that are unrelated to the companies themselves, and the
amount of debt being employed has increased the risk of investing in general.
will go back to the way they were when Peter Lynch, Benjamin Graham and Warren
Buffett understood the markets before prices were set by hedge funds
speculating with borrowed money but thats unlikely to be
In fact, Morgan
Stanley economist Gerard Minack is now suggesting that a 25 year bull market
in the financial sector is coming to an end. Over the past quarter century,
financial sector profits in the US (banks, investment banks and fund managers)
have gone from 0.5% of GDP to 3.5%, and the sector is now much
larger than manufacturing (the crossover took place 10 years ago so that finance
now represents 18% of the US national income versus 12% for
The idea that
the hegemony of the financial sector is coming to an end sounds pretty appealing
to me, and maybe its true, but the truth we have to focus on for the
time being, until that happy day arrives, is that the financiers rule the
world and over the past few years they have buggered things up -- (Australian
for messed things up).
In late July,
market psychology swung totally from greed to fear virtually
overnight. Suddenly it was doom and gloom everywhere and we were all going
to be rooned, as the credit crisis spread from sub-prime CDOs
to long-term corporate debt, to short-term commercial paper and to the overnight
The London and
European interbank cash flows seized up entirely and the European Central
Bank was the first to step up and pump cash into the system. Other central
banks quickly took it up, the cash pump, and then a bit more than a week ago
the US Federal Reserve Board loosened up whats called the discount window,
through which it lends money directly to banks cutting the rate by
0.5% and letting them keep it for 30 days instead of having
to pay it back next day.
cash market around the world is now awash, and banks that need some readies
have got plenty. Then last week, Bank of America coughed up $2 billion to
the largest US non-bank lender, the struggling Countrywide, and now it seems
to be OK, too.
As it happens,
the Sydney Futures Exchange closed down at lunchtime for repairs mid last
month, and all the hedge fund bears switched to the physical ASX (Australian
Stock Exchange) to do their short selling for an hour and a half.
The market totally
crapped out (a loose technical term), falling 150 points, and our good mate
Charlie Aitken promptly and correctly called it the bottom in Eureka Report
BEFORE the Fed cut the discount rate not because hes some
wizard market timer but because he is on the lookout for bargains and knows
them when he sees them. Given the flow of profits and the prospects for the
fundamental economy, the prices he was seeing were great value.
Charlie jumped into the pool with a splash shouting THE WATER IS FINE,
CMON IN, I hung back wringing my hands and worrying about whether
its going to get cold and choppy again. Typical. If only I had re-mortgaged
the house and gone long that Thursday lunchtime I would have caught the biggest
week in 32 years and I could retire now. This could be seen as encouraging
high risk behaviour, i.e. next 150-point drop wade in.
But it was OK,
because I had been too busy reading Peter Lynchs book about value investing
to sell when the market was falling, so I was still fully invested last week:
I went down the Big Dipper in late July early August and then up again late
good fun watching the bulls and bears slug it out and watching the market
temperament switch from greed to fear and then back to greed again, as long
as youre not running around betting the house on picking the peaks and
As Alex Green
of The Oxford Club wrote recently: Great market timers exist only
in the land of garden fairies and elves that live in hollow trees. Superior
stock market performance is the result of security selection, not trying to
pick the next rally or correction.
Anyway, I think
there are two profound changes taking place in the world that are feeding
my caution about the investment environment, and changing the way I think
about the future:
1. A permanent
increase in volatility and risk has taken place that will increase the demand
2. A major acceleration is now occurring in the long term transfer of economic
power from the United States to Asia and, to a lesser extent, Russia.
Data from the
US Federal Deposit Insurance Corporation shows that $US1.4 trillion worth
of sub-prime mortgages were securitised between 2001 and 2006. I have
seen estimates that suggest up to $US500 billion of these (more than a
third) are bad loans. Fed chairman Ben Bernanke estimates that there
will be losses to the banking system of $US50100 billion.
These are scary
numbers. Moreover, the level of mortgage resets that are causing the defaults
is still rising and will continue to be high for at least 12 months.
the International Monetary Fund, we have seen $US100 billion of resets since
of futures broker ICAP estimates that there are over $US650 billion
of adjustable rate mortgages (ARMs) to reset over the next 18 months, and
the intensity of the resets is going to rise: the maximum reset flow thus
far was $US25 billion a month in May 2007. This is expected to rise to about
$US40 billion per month in early to mid-2008, as the glut of 2006 vintage
sub-prime mortgages adjust. As the intensity of resets rises, the flow
of defaults is expected to rise.
In other words,
the cutting of the discount rate a week ago was not the end of the sub-prime
crisis it has really only just begun, and the consequences are unpredictable.
we have shifted to a higher volatility world the unsustainably low
volatility, high complacency period of the past few years, which led to the
risky lending practices in the US, is over.
again: Volatility now is about where it was before LTCM (Long Term
Capital Management) blew up (1998). We should not expect it to settle back
down to old levels.
this, prudential reserves held to cover the market risk of any given asset
will not return to H107 levels. An increase in prudential capital requirements
is a permanent increase in the cost of carrying any asset on the balance sheet
and given the increase in the cost of carrying assets, the value
of assets will have to fall.
a direct consequence of the increase in volatility; the spell has been broken.
If the cost of carry (the 'carry trade') has increased, the price of assets
must fall, as the required rate of return has increased. As a result of
this, we should not expect that asset values, even outside the sub-prime mortgage-backed
security class, will return to their previous levels (all other things equal).
of the still-unfolding sub-prime crisis and the related increase in financial
volatility, requiring an increase in prudential capital, has still got a long
way to go.
Whether it gets
a lot uglier from here depends largely on the actions of the worlds
central banks, and specifically the US Fed. If Bernanke reacts decisively
to any signs of a major collapse by cutting the Fed funds rate (the rate at
which banks lend to each other, as opposed to the rate the Fed charges them
for money, which is the discount rate) then perhaps everyone will muddle through.
I really hope so.
I think that
$US1.4 trillion in sub-prime mortgages over five years has created the
conditions for a significant acceleration in the shift of economic power from
the US to Asia. That shift was happening anyway because of the build up
of current account surpluses in Asia especially China and current
account and budget deficits in the US, largely as a result of Americas
habit of building debt to spend on wars as well as unsound mortgages.