Neuroeconomics, Asia, Cash Balance and “Total Return”

This weekend, while the east coast of the US was preparing for the season’s first major snowfall, Ruth and I were at the annual meeting of the Trustees of the California Institute of Technology.

Professor Antonio Rangel

One of the benefits in attending meetings of the Caltech Board of Trustees is to listen to various presentations of very learned professors. Professor Antonio Rangel, whose work we support, discussed the research he is conducting at Caltech’s Rangel Neuroeconomics Laboratory. His work shows that the brain assigns mathematical-like values to various choices, which leads to decisions. The values assigned to gains and losses can be different. (This is the case in selecting appropriate funds for the cash balance pension fund discussed later in this blog post.) According to Professor Rangel, an increasingly rapid serious of decisions leads to mistakes. Patient personalities tend to make better long term decisions. (One would hope those investors who experienced a decade-long trading range will be rewarded by an eventual upside breakout.)

Why Asia?

In response to my comment in last week's blog, "buy Asia," I note the following reasons why Asia should be important to investors:

• India needs 1000 new universities within ten years. India is likely to lead the world in mathematically based programming, and China may lead in Engineering and Physics; both will need to catch up with Korea, with the most PhDs per capita.
  
  
• Asian assets are expected to reach $4 trillion by 2015, driven in part by local mutual funds and other institutional vehicles.
  
  
• The Korean National Pension Service is growing at $2 billion a month.
  
  
• Thailand and India have government matching, voluntary contributions for non-government workers.
  
  
• Slightly more generous retirement plan contribution limits will be allowed in the US next year. Increasing the limits of 401k and IRA accounts may lead to more flows into the long term portfolios of investors (including the working wealthy), which will enlarge the amounts to be invested internationally.
  
  
• More money is likely to flow into Asian funds and securities. Asian investments will be attractive to US and European investors on a comparative basis, and to Asians themselves with their growing cash piles.
  
  
• Merrill Lynch expects the United States to suffer another credit rating downgrade, a recognition of the long term decline in the quality of our country’s credit.
  
  
• Asian countries are carrying less debt than the US and Europe relative to the size of their economies, and lower levels than in their earlier crisis periods.
  
  
• Chinese stocks have been in a decline at least for one year, while China's economy continues to grow, albeit slowing.
  
  
• Despite the current image, the Japanese market is gently rising.

Cash balance pension fund / absolute return mismatch

I have been asked to create an investment strategy for a new cash balance pension account. This particular account will treat the loss of a dollar more painfully than it would welcome the gain of a dollar. In researching the proper approach, I have identified a conflict in the naming implications between the institutional and mutual fund worlds.

People in the institutional world are comfortable with the term "absolute return," meaning vehicles that are designed to produce a specific numerical return, e.g., 4 percent regardless of what the general market indices return. Some of the smarter institutional investors are dropping the term “absolute return” for various Long-short and derivative-laden investment vehicles. The term is not used by responsible people in the mutual fund business because some might imply a type of guaranty. Thus, I can not turn to an absolute return mutual fund category. As is often the case, I have to devise my own screens to produce a list of candidates. In terms of equity funds, my criteria are:

• Twelve month fund dividend yields between 3 and 6 percent,
  
  
• Assets above $100 million,
  
  
• Expense ratios below 1.25 percent,
  
  
• Turnover rates below 100 percent, and
  
  
• Active portfolio manager tenure of ten or more years.
  

One could argue I am being too restrictive. Nevertheless, I am coming up with a list too long to conduct further, in depth research. Please note that for the moment I am not restricting my search to domestic funds, however considering the nature of the cash balance pension plan, we are initially restricting our search to SEC-registered vehicles.

Does anyone in our blog community have some additional or better screens to use? If so please contact me quickly at aml@Lipperadvising.com.
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To Avoid Moral Hazard: Buy Asian Equities, Hold Cash for Redeployment and Sell High Quality Bonds

This week’s blog is based on thinking about the signs shown for “Occupy Wall Street,” seeing the video rendition of “Too Big to Fail,” remembering the insight of a blind leader, looking at extreme numbers and watching the NY Jets beat a better team. Part of the intellectual handicap we all have is that our views of history are shaped by commentators who lack full understanding of what they thought they saw or heard.

D/F + TBTF + OWS = Bigger failures - - bigger opportunities

By now the media savvy recognize "OWS" stands for Occupy Wall Street which has gone global as sites of anger, frustration, and the willingness to break laws. "TBTF" abbreviates the title of the book entitled Too Big to Fail, which was made into a movie which was rebroadcast last night. "D/F" is my symbol for the Dodd Frank law that is being imposed on the US financial and economic community, which has implications to financial communities around the world. This witches’ brew of maladies will, in my opinion, lead to bigger failures and greater disruptions to global progress and at the same time open up new opportunities for the wise to make money.

The complaints

Two of the complaints coming from the inhabitants of the various “rescue encampments” are first, the banks got bailed out of their problems and we “ordinary people” did not; and second, we have selected various financial institutions to receive future bail outs whenever they get into trouble. I do not expect the strident to allow me to share my personal historical perspective from both fifty years of professional investment experience and having listened to other professionals who went through the changes in the financial community for over one hundred years.

Ever since the “Money Panic of 1907,” (if not before), financial people have been concerned about the potential damage that a concerted “run on the banks” could do to individuals, themselves and the community as a whole. In its simplest form, banks collect deposits and loan most of their deposits back out to the community in the form of demand loans or term loans. Banks require interest income from these loans to pay for deposits, other expenses and to build reserves to cover for periodic credit losses. No bank keeps enough cash on hand to meet redemptions of all its deposits. Thus, if there was a “run on the bank,” the bank would attempt to call all its demand loans and as much of its term loans as possible. The news of a run on one bank is likely to cause a run on other banks. This fear is what led to the founding of various government financial agencies like the Federal Deposit Insurance Corporation (FDIC) in the 1930s. Those of us who have spent our lives in the mutual fund world have harbored the same fear about “money funds.” As a matter of fact, Jack Bogel, the first president of the Vanguard Funds, has told of his fear of one day turning on a Philadelphia television news program and seeing a helicopter reporting on a long line of people formed around Vanguard’s Malvern offices who want back the billions in their money market funds. Both the current US administration and its immediate predecessor felt that they had to “do something” to prevent harm to ordinary citizens. In the government’s eyes, it was bailing out individuals and small businesses. One could argue that the government and financial community leaders should have let various banks fail, and individuals lose the value of some of their deposits. Such inaction could well have led to a lack of confidence in the financial community that supports the government’s funding requirements. Bank failures and government defaults have been going on since their creation without total loss of economic progress.

The way the potential run on the banks was headed off was to force Federal government or Federal Reserve Bank loans on the banks, which led to the belief that certain financial institutions were so important that the society could not afford to let them fail financially. In other words, they were too big to be allowed to fail. There is a term for this which is “moral hazard,” which means that the government will permit these groups to make significant financial mistakes and they will still be bailed out. This concept goes directly against the wisdom of a very successful regional brokerage firm. On the occasion of the annual meeting of its partners, I was paid to give a speech on how I saw the brokerage business evolving. This was in the early days of Power Point graphics which I used in my slides to support my conclusions. To my horror, no one told me the chairman of the firm (who was sitting next to me) was totally blind. Trying to recover in my conversation with him, I recognized he did not have to see the charts, he intuitively knew what I was talking about. We then discussed what his firm should do in the face of the increasing market share that larger brokerage firms and banks were taking out of his market. I inquired why his very successful firm had a small capital base, (where the substantial profits were paid out at the end of each year). He replied that he did not want to accumulate firm capital, for he feared that his partners would invest it poorly. Too much capital would lead to putting undue pressure on the firm.
Today, I wonder whether firms that get into financial trouble should be bailed out. The FDIC has a model that a failed bank’s deposits and sound loans get auctioned off to a competent nearby bank, and the losses to be absorbed by the bond and shareholders of the failed bank. In the UK, the banking authorities are trying to “ring fence” or separate the retail deposits and loans from the business loans and investment activities of the bank. (In some ways they are trying to put back in place the Glass–Steagall Act in the United States.) This weekend in Europe, the powerful countries are trying to determine how to help their national banks with faulty sovereign debt and underwater loans, either through a materially stronger bailout fund backed by a central bank, or a facility that would insure some of the value of the loans. To me, the insurance scheme has less moral hazard.

All governments need to be careful about changing established ways of conducting business. In the US, we have merged investment banking with commercial banking rather than keeping them separate and in some cases, competitive. Almost all of the losses suffered by the large investment banks were in their investments, particularly illiquid real estate. Similarly the Savings & Loan scandal of the 1980s was caused by pulling down the interest rate advantage the S&Ls had in attracting deposits for making local home mortgage loans. Once there were level interest rates, many S&Ls went into commercial lending that they were ill-equipped to do, and commercial banks built up their home mortgage business without the requisite local and personal knowledge of hometown people and properties. Further, when the SEC introduced price competition in brokerage commissions (as distinct from service and research competition), it changed the game which led to the need for capital to facilitate trades. The SEC compounded the problem when it encouraged multiple sites for trading, executions, and reporting. To some degree, the fragmentation of the market has led to increased volatility.

Many investors believe that the increase in volatility is a sign of increased economic risk. I think you have to look at volatility as any time series, and dissect it to derive meaning. In Saturday’s WSJ, which is what they are labeling the Saturday edition of The Wall Street Journal, there were two items that address volatility. “The S&P 500 would be up 16% for 2011 if the three biggest declines were excluded and it would be down 13% if the three biggest daily gains were excluded.” The message that I get from this data is that we have been in trading range markets with periodic extremes. For the technical or chart analysts, this pattern is either of a distribution where stocks move from strong (in theory, “bright”) sellers to weak (presumably dumb) buyers, or it is an accumulation by bright investors picking up bargains from tired or discouraged speculators. Only time will tell which is correct when a significant move breaks out of this trading range. My long term bet is for a breakout on the upside. In a contest, the bright or better team doesn’t always win. We just returned from seeing the New York Jets, with their home in New Jersey, play football against the San Diego Chargers. While I was cheering for the Jets for “hometown” and other reasons, I had to admit that most of the time the Chargers played a better game, except for two pass interceptions which led to a Jets victory. Thus, it is often better to be lucky than smart; and I hope that while I understand the negatives facing us, I hope to be lucky on the upside.

To put my neck out further, I was a member of an investment panel addressing a group of Caltech alumni and scholars. Our final question was what would we buy, hold, and sell. We ran out of time before I could answer, but as some of that audience are also members of this blog community, I thought I should very briefly give my answer which we can discuss in future posts. I would buy Asian equities, hold cash for redeployment, and sell high quality bonds.

What would you do?
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Frustration is Widespread and Normal

OWS

As almost everything in the modern telecommunications world is abbreviated, for those who have just landed on the planet OWS stands for Occupy Wall Street. Similar to the “Arab Spring” or the various color revolutions, OWS activities were spread through social media, in this case to a reported 868 cities around the world. The apparent rationale for crowding a large number of young people and some older into a constrained space easily accessible to the media, is to vent their frustration as to the lack of jobs and other grievances. (This Saturday when we were briefly visiting Carnegie Mellon University, I noticed a sign on a very crowded bulletin board advocating to bring OWS to Pittsburgh to “occupy” Mellon Square in the middle of the financial district. No one appeared to be taking any notice of the signs; this group of very smart students appeared to be focused on their difficult studies and other normal university activities.) From what I read, the crowd which does not appear to have a leader, is frustrated with their joblessness, as we are for them, but also upset about the distribution of wealth in their communities. They seem to believe that the financial services companies have deprived them of what is, in their opinion, their rightful share of the wealth of the community. They may fear that the coming cutback in government spending will reduce their lot in life even further.

At the moment, these masses of people can be properly called a crowd, not a mob. Mobs have leaders, often self-appointed. Mobs led on by their leaders can express their anger in non-violent activities. All too often, non-violent activities in the eyes of some, impinge on the rights/privileges of others. To protect both sides, the forces of “law and order” try to keep each group separated and calm. Unfortunately, all too often one side or the other, often the original protesters, lash out against “the authorities,” creating a series of violent eruptions, which can be taken to its extreme: open rebellion. Historically, some of these rebellions can lead to bloody revolutions, which in the end defeats both sides, for example the French and Russian revolutions. This risk is why it is wise for global investors to keep a wary eye on these crowds.

OWS concerns

Some of us are also frustrated. We are frustrated with the current generation of protesters who in many instances have not prepared themselves to find work in a changing world and often appear so self-centered that they are not helping out with their extended families or charities. Most importantly, they do not recognize that they themselves, their parents, and their grandparents have benefited from a society that has been willing to give us more services than we have been asked to pay for in taxes, fees, or volunteer work. In the US we have allowed a number of our school systems to cease teaching either civics or geography. Civics, properly taught, would have emphasized the individual’s responsibility to the community and the society in general. Geography is essential to economics. One quickly learns that land, water, and other resources are not equitably distributed. Some elements are better than others and are worth more. The fights to gain these basics shape our world’s history. Any reasonable students of geography and therefore economic/military history, would focus on the incipient power of China. They would be able to explain that except for about the last two hundred years, China has been the leading economic (and in some ways, intellectual) power in the world. With this knowledge, one would be wise not to play the “China Card” with the political crowd.

My own frustrations

The people in the milling crowds are frustrated because they do not have the appropriate tools to solve their problems. In a very much less important way, I am frustrated in my inability to answer a mutual fund search question. I was asked by a very savvy investor to come up with one or more “deep value” mutual funds. As with most terms in the world of funds, there are not complete definitions, but a series of concepts. One would think with the ability to tap into my old firm’s ninety-odd fund classifications, I could easily find a couple of “deep value” funds. This is not the case; so I must rely on artistic instincts to complete the search. In the past, poorly performing funds would excuse their poor performance by saying they were holding securities that were priced with big discounts to their intrinsic value or even better future prices. Over long periods of time they never get into a market that recognizes the values they perceive. To avoid waiting for the market to recognize these managers’ brilliance, I am looking for funds which base their choices on three attributes.

The first attribute is a massive change in the supply/demand equation for the products or services of the company. Often this kind of search puts one into commodity types of companies. The risk of getting a massive change on the upside is that it can also go the other way. Further, often changes in government regulations can cause significant alterations in the supply/demand balance. Because of the sources that cause change, the successful investor has to have deep contacts with the users and regulators of these products and services.

The second attribute is simply price changes. Not the kind of changes that emanate from the first attribute, for that is a given. The second attribute focuses on a relative price of a company and/or a sector relative to the larger universe of investments. There are times when the relative value spread gets to be too large between what is considered to be the best investment and second or third or possibly the tenth best investment. The skill required here by the portfolio manager is to pick up the changes in momentum between the current leaders and the others too far behind. Trading skills are very important for this kind of manager, both in stocks and other financial instruments.

The third attribute is usually an abrupt change in management which comes with radical changes in policies and how the company is run. There are activist managers who try to force these kinds of changes. Sometimes they are successful, sometimes not. Change is not always good for the investor. Occasionally a management change in one company makes other stocks more attractive.

All three of these attributes require a great amount of patience on the part of both the fund manager and the fund investor. A successful deep value fund(there have been some) should not be the only fund in one’s portfolio. As a manager of accounts devoted to a portfolio of mutual fund investments, we would normally own funds that have a variety of characteristics.

I am developing my list of “deep value” candidates; I would appreciate suggestions from any member of this blog community.
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Steve Jobs and Lessons for Fund Owners

We have all benefited from the life and genius of Steve Jobs. One can only speculate whether in our own lifetimes, Apple Computers, “Toy Story,” the iPad and the iPhone would have been produced and at the prices we paid, without the guiding force of Jobs. He married Art with Technology, and came up with magic to give us products that we didn’t know we wanted, but demanded nevertheless. His attention to detail, particularly to the fit and feel of Apple’s products, was amazingly accurate. Part of his genius was organizing the supply chain of essential parts that would be assembled into his finished products. Knowing of his medical condition, Steve Jobs left his company with new products planned out for the next four years. He built a team of successors that he felt would carry on with his goals. Clearly, I am a fan. The smartest thing I ever did outside of marrying Ruth was to give my late, learning-disabled daughter an Apple IIc. Because of its intuitive operating system and keyboard, she was able to communicate with a whole new world of people and learning. Important disclosure: I personally own Apple shares which I received many years ago as a distribution from a closed-end fund. Luckily I kept half the position; since then, I stupidly sold a portion to take an outsized profit to offset some realized losses from other transactions and to free capital for new investments. Like Steve Jobs, I was able to make mistakes and learn from those errors. Jobs certainly did make blunders, several which could have bankrupted Apple if others had not intervened. Despite the very fact that as good as he was, he had a combination of tremendous successes and near-fatal mistakes. These extremes are somewhat similar to many very successful fund portfolio managers.

Lessons from Fidelity Magellan

Chapter 16 of my book Money Wise details some early lessons from the progress of Magellan, from its initial restricted launch through some of the later portfolio managers. This chapter should be required reading for all those interested in the economics and portfolio history of the mutual fund business. While there have been many portfolio managers of the fund, none were better than Ned Johnson and Peter Lynch. Very recently a new portfolio manager has replaced one who produced lackluster results. To some degree, his appointment is recognition of less-than-successful succession planning, which highlights how difficult the task is, particularly for the management and board of Apple. In terms of Magellan, like with Apple, there are two elements that are required to make succession work. The first is the outward results: e.g., will the iPhone 5 and iPhone 5s continue Apple’s astounding growth? To do so, these devices will need to open up new markets as well as to convince owners of Apple’s older versions to crave these new phones. On the fund side, I wonder, will Magellan become a performance leader once again? The other key element to whether a successor works out well is on the business side. Can Apple’s management keep its gross and net margins where they are, through managing both the supply chain and distribution margins up to the current level? For Magellan, the issue is more challenging. The fund is largely a retirement vehicle, as distinct from a performance vehicle; its shareholders are different and getting new flows from retirement plans will take a lot of work. Further, at one point in time Magellan was the flagship and largest fund within Fidelity. It is not today, which raises the question as to whether it will get all of the top attention that may be needed to succeed in a much more competitive world.

I have a reasonable degree of comfort in the prospects for Apple over the next four or so years; I approach the decision in terms of Fidelity Magellan differently. If one already owns shares in the fund, I would not redeem them until one sees the next portfolio of the fund after the new manager took over. The key that I would be looking at is to see how many of the old holdings are left in the portfolio. In the case of someone contemplating buying into the fund on the basis that the new portfolio manager has a better record than the old one, I would wait until the publication of the second listing of investments in the portfolio. I would be interested in whether the portfolio looks like his old portfolio or whether he is branching out to new names and policies.

Applying successor concerns to Fairholme

As famous as Peter Lynch was during his high performance years, Bruce Berkowitz has been shepherding his Fairholme Fund for the eleven years between 2000 and 2010. In all but two of those years he handily beat his peer group as measured by the Lipper Large Cap Value Fund Index, in most cases by ten percentage points. (For our UK members of this blog community, the name Fairholme may seem to be familiar, it is the name of the street where Bruce lived while he was in the brokerage business when he was in London.) Bruce’s fame was such that Morningstar named him as the best equity manager of the decade. As with Peter’s Magellan fund, the outstanding performance attracted a huge amount of inflows. So much in the way of inflows, that Fairholme was larger than Lynch’s Magellan when Peter was managing it. (Fidelity merchandised Magellan after Peter Lynch stepped down, to a point that it had assets over $100 billion, and for a time was the largest active stock fund.) Unfortunately, we have seen poor performance patterns appear after great performance. For the twelve months ending September 30th, Fairholme was down -22.20%, compared to the minor -3.54% loss of the Lipper Large Cap Value Fund index. All of the decline could be attributed to Fairholme’s poor third quarter of -25.47%, compared to its peers of -16.67%. Bruce’s concentrated portfolio, with heavy emphasis on financial-related stocks, was hurt. Is this poor performance similar to the period when Steve Jobs was producing poor financial results and lost control of his own company? Only the future will tell whether Bruce can snap back, though I hope so. For many years until he moved to Florida, his New Jersey office was about a mile away from my office.

Just as I focused on Magellan in terms of both the investment and business side, I think shareholders need to examine Fairholme. Bruce is managing what he does with a small staff of investment and administrative people. If something unfortunate was to happen to him, I do not see a succession plan in place. Who could run both the portfolio and the business? Unlike the present day Magellan where existing holders may be wise to wait to review the new portfolio manager’s holdings, my fear is that Fairholme’s holders won’t be patient. This does not appear to be a Steve Jobs type of succession in terms of people and products.

Why did I focus on Fairholme and succession issues?

For awhile we did use Fairholme in a number of portfolios that we manage; however we limited the size of the commitment below what we would have done had there been a well thought-out succession plan. Further, we cut back our position, as the fund’s analysis was very different than our views on specific holdings, most particular in the financial sector. (Please bear in mind that I manage a small private financial services fund.) The purpose of sharing my views is to indicate some of the ways I analyze funds and fund managers. Further, as with all good analysts, I could reverse my views on the basis of new information and once again build positions in Fairholme. When Steve jobs returned to Apple, both he and the company were better off than before he left. Both had matured and were ready for exponential new growth. From the time he came back until this last week, the price of the shares of Apple went up 7000%. Thus, there is always hope for a great second act.

Wall Street protesters

I am gathering my thoughts about the significance of these demonstrations. I may devote next week’s blog to thoughts about the meaning of the “occupations” for the rest of us. Please share your thoughts with me on how I should think about these events.
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London Calling, with Concerns

As regular readers of this blog may know, my wife Ruth and I spent last week in London; several days with temperatures in the 80’s (F). In my many previous visits to London, I have found some of the most sophisticated investors in the world. Topic one for them last week concerned the problems with the Euro and how that would affect other markets. In addition to those concerns, now that I have a Facebook group, I am getting regular inputs from old and new friends who have strong views as to what should be done by various politicians. All of these concerns expressed by many people far beyond the small world of the financial community has led me to think through the large and growing deficits being experienced in Europe, the UK, Japan, and the USA.

There are two causes for this crisis in my opinion. The first is that at least since the great depression of the 1930s, people have believed that they needed help beyond their means and wanted the various governments “to do something.” The second cause is that in our elected societies we are governed by politicians, not statesmen. A statesman has a long term view as to the correct path, often unpopular, and tries to convince people as to the correctness of his/her view. Politicians, always looking toward the next election, try to find an already exiting parade of supporters for a particular policy and place themselves as the leader of the parade. In each of the countries and regions mentioned above, both the governments and their principal oppositions are headed by politicians, as distinct from statesmen. To my analysis, the structural problems facing most of the democratic world is that for about 80 years (or three-plus generations), we have been directly and indirectly spending increasingly more than we have been willing to pay for in taxes as well as fees.

I do not want to appear as an apologist for the current US President, but we need to find a parade of strong volunteers to both cut our spending and to advocate for paying a larger portion for what we receive. As we dug this hole in our national balance sheets over three-plus generations, we should expect the change in our life patterns to take one or more generations. While there are likely to be some “band aid” attempts, progress will be slow until there is general acceptance of shared pain for all. This pain will come in lots of different ways. The deficit problem cannot be solved by simple eliminations, but only by a thorough review of every entitlement and subsidy each of us individually receives; for example, tax deductible mortgage interest and gifts to charity, (which would hurt me). The overall solution will be granular and thus will take lots of time. What I have outlined is not pleasing to anyone, perhaps particularly not to investment market participants.

Portfolio Reactions

The more people contemplate the deficit issues, the more bearish some react. As we know, the third calendar quarter was ugly in terms of performance; and as time passed, market participants became increasingly bearish. One example of these bearish actions is that the short interest ratio rose almost 44%, from 2.92 days to 4.2 days for NASDAQ stocks in just 15 days to September 15th. Over the same period, the short interest ratio of the supposedly higher quality stocks on the NYSE rose to 3.7 days from 3.2 days, a gain of 16%. (This measure is of the number of days volume of transactions that would be needed to cover all of the existing short positions. While the increase in shares sold short is an immediate bearish sign, keep in mind that when the market starts to move up many of these positions have to cover to avoid losses.) One of my personal concerns about the growth in the use of Exchange Traded Funds (ETFs) is their growing short positions. The two largest short positions on the NYSE are two ETFs, as a matter of fact, of the 40 largest short positions, ten are ETFs.

Many of the investment managers that I saw in London use European based ETFs. (Not of minor importance is that apparently the UBS trading fraud was conducted in ETFs, which were meant to be hedged.) I do not believe that there is equivalent public data on European ETFs short positions, but considering there is a smaller retail market in Europe, my guess is some of the short positions could be larger than their equivalent US ETFs.

Is there any good news?

Yes, there are three positive elements that could be of some help. First, the chart pattern on the Dow Jones Industrial Average is displaying something of a bottoming since the August decline. (However, there is not as helpful a sign in the transportation average; this could have some bearing on the Warren Buffett discussion below.) The second positive note is that the Barron’s Confidence Index, comparing high grade bonds with intermediate grade bonds, rose 2.4 points last week to a 70.3 level; most of the time this index moves less than 1.0 point per week. Often when the index moves up it is good for stocks, for it shows that investors are willing to take on more risk (intermediate quality bonds). The third somewhat misplaced positive, in my opinion, is the bullish reaction to Warren Buffett’s decision to buy back Berkshire Hathaway stock. I believe one of the best things about Mr. Buffett is that he corrects some of his mistakes. For many years, he has only bought companies for cash and has not used stock for acquisitions. Because of the large size of the acquisition of Burlington Northern, he had to use stock to supplement his cash to buy the railroad. (I believe despite the uncertain price pattern for the transportation average, over time this will prove to be a very successful investment.) What he is really doing now is buying back at a lower price than what was used for the acquisition, and in effect turning the purchase into close to an all-cash deal after the fact. With the buyback, I believe, he is not making a market call. Buffett and/or his new investment manager is probably buying some “cheap” stock also.

Investment Posture

As indicated, deficit solutions will be a long time coming and there is increasing speculation on the downside; nevertheless I believe that one should view the current market and periodic dips as opportunities to add to sound investments. The next 100% move will be on the upside, even if it takes a long time.

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