Finally, a post about the economy.

I don’t claim to be a macroeconomist, so take what I have to say with a grain of salt. And I am certainly not a market prognosticator, so please don’t interpret what I say as a prediction for the direction of the stock market. But the more I hear about the state of the U.S. economy, quite frankly, the less confident I can be that it will flourish in the near (5-10 year) term. Let me detail several stylized facts that, taken collectively, lead me to this conclusion.

#1. The dollar continues to weaken.

#2. At this time last year the yield curve was flat, portending recession.

#3. Housing price run-ups have historically preceded recession. Need evidence? Check out this new NBER report.

#4. The nation is addicted to debt, both at the individual and governmental levels. The federal government’s chronic deficit spending has, in effect, caused us to sell of a great portion of the wealth to which we as Americans once had claim simply to finance our overspending. This appears to be driven only by political pressures and not by any level-headed economic analysis. As individuals we have an insatiable desire to consume, making even the wealthy prone to borrowing. This high leverage leaves us in a precarious position, as it eliminates any buffer against the inevitable downturns of the economic cycle.

#5. The subprime meltdown was caused by greed, on both the lender and borrower sides of the transactions. The widespread securitization of mortgages meant mortgage brokers, underwriters and even guarantors had little concern for traditional loan-approval criteria (like income!). This is because they were completely severed from the mortgage after the transaction giving them an incentive to make the deal happen at any cost. Thus, with no ultimate culpability, the consequences of defaults and resulting CDO failures will be shared among all players in the financial markets.

#6. The Fed cannot solve this problem with rate cuts. It can solve liquidity problems with monetary policy, but the problems this time around stem from outright insolvency. In fact, short-term stimulus initiatives – including Fed rate cuts – will only encourage further debt-financed spending. So while the issue of liquidity may be resolved in the short term, we have not gained any ground since presumably we would experience even more insolvency. Thus, we have cut off our nose to spite our face.

#7. Psychological factors (while relatively unimportant in the long term) will weigh heavily in the short term. The advent and popularity of mortgage backed securities creates an environment of uncertainty, as judging the credit quality of the underlying mortgage becomes close to impossible. This breeds contagion.

#8. Interest rates, in general, have no where to go but up. Especially with the recent cuts we are at very low historical rates. The long bull market that began in the mid-80s and is now coming to a conclusion coincided with an enormous fall in rates. This juiced the returns on equities in an economy that, while growing, was not keeping up with the growth of its equities. This is because as rates fall, the discount rate used in cash flow valuation falls, giving us higher present values. This corresponds to higher stock prices and helped pushed earnings multiples far beyond where they have historically resided.

When I consider all of these things collectively I can’t come up with any convincing argument that we won’t end up in recession. What is more, there is a decent amount of evidence that what happens will be even worse than recession, a prolonged economic downturn.

The financial markets, and in particular the credit markets, have changed tremendously in recent years. Americans more and more feel no moral obligation to repay their debts. Bankruptcy has lost its stigma, and with enormous worldwide lenders making loans, there is little personal or social pressure to behave responsibly financially. This trend has the potential to completely uproot our existing financial system. That disruption is reason enough to expect the worse.

I don’t mean to sound like a complete doomsayer, because I do think that this country will continue to thrive in the end. And I will continue to invest in American stocks. I just think we are in for some unpleasant surprises in the near future. So why not take the good with the bad? This upheaval will undoubtedly produce some bargains when investors panic. Maybe we will even have the chance to pick up some Berkshire on the cheap.

The Agony of Defeat

This is one of those times when I just don’t know what to say. Perhaps it’s my relative inexperience, perhaps its just human nature. But the market is tanking, I am losing money and I can’t help but second guess my past decisions. It is important not to make emotional decisions, but to tell you the truth it is hard to tell if the decisions I am making even are emotional. By that I mean, it’s tough to know whether I am rationally changing my own perceptions, or whether I am allowing the pundits that pervade the news sources from which I get my information to sway my opinion.

I know not to let fear or greed influence my decisions, but how do I know if they are? I know to let the market be a tool, not a guide, but it is hard to rely solely on my own interpretation of available information. After all, how arrogant must I be to assume I am right while everyone else in the market is wrong? Bottom line: this is the type of environment when investing is most aggravating.

Of course the biggest losses have come from the financials. Those are the easiest to brush off too, since it was much more of a macroeconomic phenomenon than a company-specific one effecting these losses. It is the individual picks that cause the most distress.

For me, the one individual stock for which this frustration is most pronounced is Sears Holdings. I’m not really sure what to think about this investment anymore and at times I struggle with the question of whether my original purchase of the stock was an emotional one, or one based on a rational consideration of the facts. The question is justified. Ever since Business Week asked in November 2004 if Eddie Lampert was “the next Warren Buffett,” folks started jumping on the SHLD bandwagon. Maybe that was reason enough for me to stay away. But I didn’t. I jumped right alongside them. Now, it seems, they are all jumping off that bandwagon. Why? Let’s talk about that.

A year ago, the theory was that Lampert would use Sears as a vehicle by which to invest in other businesses (a la Warren Buffett and Berkshire). Folks debated this issue, but the theory that Lampert saw the company as merely a turnaround lost out to the competing theory from the bulls who had more faith in Lampert’s investment prowess. As such, the story went, whether or not the retail business really grew (Lampert claimed he wanted it to nonetheless) was not of top concern, since the plan was to merely use the cash flow from Sears’ current operations to make better investments outside the company.

But now, it seems, the retail business is so bad that it isn’t even generating that cash flow! So Lampert is left with no cash to invest, at precisely the time when the market might be creating the best bargains. Remember, this is a company directly competing with Wal-Mart, not an enviable position in which to be for anyone.

In addition, everyone thought Sears’ real estate assets were a hedge against the performance of the company’s retail operations. Ha. What does the market for commercial real estate look like these days?

The plan appeared to be working because Lampert did, to his credit, do a great job cutting costs and boosting profitability. So even as sales lagged income rose. But the benefit of cost cutting is limited by the company’s sales. Don’t get me wrong, Eddie Lampert is certainly one of the most successful hedge fund managers in recent years and obviously a very bright and astute businessman. I love the way his shareholders’ letters are written and the obvious parallels we can draw between them and Berkshire’s. But that doesn’t change the fact that he must begin by making sure the utterly lousy retail business he is burdened with doesn’t completely fail.

Part of me feels foolish for even writing about this. It has been written about to death. And 99% of that writing is motivated purely by the hope that Business Week was right. Nobody knows at this point if the company will survive long enough to turn in to a new Berkshire. But we hope it will.

Note the word “hope.” This is an emotion. And if I bought SHLD “hoping” that it would become something huge then I was greedy, because there was not a whole lot of evidence indicating it would be. There reasonable speculation, but no solid evidence that would afford the margin of safety that I should have demanded. There was a lot that could have gone wrong that I should have considered, but I didn’t because I let the dollar signs blind me. Ah, hindsight.

I think the lesson from all of this is the following; Emotional discipline is the number one most important factor affecting investment performance. Warren Buffett has been successful because he has that emotional discipline. I think he would have passed on Sears Holdings, even as great a guy as Eddie Lampert is. But just as it is so difficult to change one’s personality, if we don’t already have emotional discipline we can’t expect to obtain it easily. And this might just make some type of structured investment philosophy that disallows the influence of emotion preferable.