Berkshire Ruminations

Wednesday, January 30, 2008

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.


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