Some Comments on Warren Buffett and the Stock Market
(March 9, 2006)
Dear Subscribers and Readers,
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Wednesday (11,005.74), this position is 135.74 points in the red – but again, given that the market is now showing signs of a classic “blow off” top, this author is betting that this position will ultimately work out.
In our weekend commentary from ten days ago, I stated that: “If we do see some more [strength in the Dow Industrials on relatively low volume and dismal breadth] on Monday or Tuesday, then this author will “break tradition” and go 75% short in our DJIA Timing System. Such a position is a very bold move on our part – but since both the financial markets and the stock markets of the world are showing signs of a classic top – this author is willing to stand both the criticisms and the volatility. Let me be clear: We are still in a secular bear market. The era of disinflation that supported a secular increase in P/E ratios during the 1980s and 1990s ended in 2000. It does pay to be a trend follower most of the time, but not when bullish sentiment is rampant and not when the market is hugely overbought and showing many signs of divergences. This author is now choosing to take such a stand.” Keeping true to our word, we added a further 25% short position on February 27th at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. We sent a special alert to our readers on a real-time basis during that afternoon and a further clarification email the next morning. As of Wednesday at the close, this latest short position is 118.26 points in the black. We anticipate covering this latest 25% short position once the market gets to a more oversold or neutral level in order to control for volatility. Clues to look out for: A daily NYSE ARMS Index of 2.0 or over, a daily jump in the VIX of 10% or over, and so forth. We will send our readers a “special alert” through email the moment we cover this latest 25% short position and (hopefully) take our profits.
Readers must be getting tired of our talk about diverges, leverage, declining global liquidity, and extreme bullish complacency by stock and financial market players by now – so let me try to be brief (for once) in this commentary and just discuss several things in as few words as possible.
We first discussed Warren Buffet and his holdings in our March 10, 2005 commentary (“Buffett Bashing in Perspective”). In that commentary (which discussed his 2004 annual report, among other things), we noted that even though the market has hardly recovered from the 2000 to 2002 debacle, Berkshire Hathaway was actually holding $40.0 billion cash and cash equivalents, or 46.6% of stockholders' equity – a record high for Buffett. We argued that the reason for such record high cash levels at Berkshire was that because equities were still expensive across the board – and sure enough, equities as a percentage of stockholders' equity at the end of 2004 totaled only 43.9% - which was also near a record low as well.
The year 2005 provided some reprieve for the equity fans in all of us – as Berkshire added to its substantial holdings of Wells Fargo, and established new positions in Wal-Mart and Anheuser-Busch (for a cost of $944 million and $2.1 billion, respectively). For the year, Berkshire's equity holdings increased from $37.7 billion to $46.7 billion – the highest absolute dollar amount on record. As a percentage of shareholders' equity, however, equity holdings totaled only 51.1%, which is the highest in five years but still substantially lower than the 61.0% reading at the end of 2000 (and not to mention the 128.3% reading at the end of 1994). Following is a chart depicting the amount of cash (and equivalents), fixed income securities and equities as a percentage of shareholders' equity for Berkshire Hathaway (not including MidAmerican) over the period from 1994 to 2005:
As one can see, cash levels as a percentage of stockholders' equity at Berkshire is actually still the second highest on record. During 2005, Berkshire agreed to five private acquisitions – two were completed at year-end, one that has already closed before the 2005 annual report was published, and finally two more that are expected to close soon. The unprecedented amount of cash sitting in Berkshire's coffers is mostly due to two developments:
- The sheer size of the company, and thus its focus mainly on large caps and large private businesses to acquire. Instead of a world of thousands of companies when Berkshire was only 10% of its current size, the world of acquisitions is probably limited to companies numbering only in the hundreds at this point. This size factor also comes into play when evaluating public companies and whether to purchase their shares. It should be noted that the two private acquisitions that Buffett agreed to during 2005 made no significant dent in its cash hoard.
- More significantly, the size of the cash hoard is mostly due to the lack of bargains in both public and privately-held companies. Make no mistake: Peter Lynch's Magellan Fund still managed to outperform the S&P 500 when it became the biggest mutual fund in the U.S. with assets totaling over $10 billion (and that was in the late 1980s!). Livermore also had no problem beating the stock market even as he became one of the biggest players in Wall Street by the late 1920s. Everyone knew Soros and Drunkenmiller was short the British Pound going into the Pound devaluation in 1992 and yet they prevailed and made nearly $1 billion in the process in 1992. Sure, Buffett had found bargains in the utility sector, pipelines, and junk bonds in recent years, but when it comes to the broad equity markets, his style of buy-and-hold has just not been in fashion since the 1990s. Will Buffett “regain his touch” one day? Sure he will. Actually, the fact that Buffett is holding so much cash right now makes me convinced than ever that he will – it is only a matter of time.
Reading Berkshire's 2005 annual report is always refreshing – as Buffett usually doesn't mince words like other Fortune 1000 chairmen or CEOs do. Therefore, when Buffett says anything of significance, we usually pay attention – especially if other analysts or the mainstream media are ignoring those words. Buried under Berkshire's equity portfolio holdings on page 15 of the annual report, Buffett flatly stated: “Expect no miracles from our equity portfolio. Though we own major interests in a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth.”
This is the statement that readers should keep in mind if they choose to only remember one thing from this report. Unlike his bearish call on the U.S. Dollar, this is the one statement that has not garner any worthy attention from both the financial and mainstream media – and thus this makes it doubly important. Predictions do not come true if the mainstream media has already written about it dozens of times or if books making those predictions are sitting on the front shelves at the local Barnes & Noble (a popular book store here in the U.S.). Skyrocketing oil? Lower dollar? Maybe in the long-run, but definitely not in the 12 to 18 months.
Speaking of the U.S. Dollar, Berkshire lost $955 million on a pre-tax basis in its foreign currency bets during 2005 – although it still has a cumulative profit of $2.0 billion. Even though Buffett's long-term views of the dollar does not change (he is still long-term bearish primarily because of the record trade imbalances), he has pared down Berkshire's foreign currency position somewhat, stating: “We reduced our direct position in currencies somewhat during 2005. We partially offset this change, however, by purchasing equities whose prices are denominated in a variety of foreign currencies and that earn a large part of their profits internationally. Charlie and I prefer this method of acquiring nondollar exposure. That's largely because of changes in interest rates: As U.S. rates have risen relative to those of the rest of the world, holding most foreign currencies now involves a significant negative “carry.” The carry aspect of our direct currency position indeed cost us money in 2005 and is likely to do so again in 2006. In contrast, the ownership of foreign equities is likely, over time, to create a positive carry – perhaps a substantial one.”
“The underlying factors affecting the U.S. current account deficit continue to worsen, and no letup is in sight. Not only did our trade deficit – the largest and most familiar item in the current account – hit an all-time high in 2005, but we also can expect a second item – the balance of investment income – to soon turn negative. As foreigners increase their ownership of U.S. assets (or of claims against us) relative to U.S. investments abroad, these investors will begin earning more on their holdings than we do on ours. Finally, the third component of the current account, unilateral transfers, is always negative.”
In the long-run, trade imbalances do matter – but in the short to intermediate run, capital (and speculative) flows will overwhelm any money flows out of the United States due to trade. Case in point: The U.S. Dollar made high after high during the 1995 to 2001 even as our trade deficit continued to worsen. Given the drubbing that the U.S. dollar took from its high in 2001 to the end of 2004, and given the extreme bearish sentiment in the U.S. Dollar (coupled with a cover article on Newsweek), there is no doubt that the U.S. Dollar was overdue for a substantial rally from such oversold levels. And finally, given the “positive carry” due to higher borrowing costs here in the United States, and given the fact that many domestic retail investors have been buying international and emerging market securities over the last couple of years (which should act as a contrarian indicator), the trend of the U.S. Dollar should remain up for the foreseeable future. Currency trends tend to last for months or even year in general – and this current rally in the U.S. dollar should be no exception. I expect the U.S. Dollar to not top out until the U.S. Dollar Index has reached the 95 to 100 level (with the Euro taking the brunt of the rally).
Moreover, this author would like to again emphasize a certain point that we have raised in the past. That is: Our trade deficit numbers may actually be significantly overstated. In Berkshire's latest annual report, Warren Buffett stated that it is no longer easy to measure the “intrinsic value” of Berkshire's businesses: “Back in 1965, when we owned only a small textile operation, the task of calculating intrinsic value was a snap. Now we own 68 distinct businesses with widely disparate operating and financial characteristics. This array of unrelated enterprises, coupled with our massive investment holdings, makes it impossible for you to simply examine our consolidated financial statements and arrive at an informed estimate of intrinsic value.” It is also interesting to note that some of the major businesses that Berkshire invests in share this same characteristic. For example, how does one exactly measure Coca-Cola's brand value? Not to mention Procter & Gamble's brand value – since traditional valuation measurements (P/E of 22 and Price-to-book of over 3) would render the stock in overvalued territory. Valuing companies like KO or PG is not an easy task – and this is where Buffett and Benjamin Graham separate paths – as the former also takes into account unquantifiable characteristics of a company such as brand value, the idea of a “moat” around a company's business, as well as the integrity of a company's management.
Our point is: The economy of the United States is as complex as ever and it is getting more complex by the day. If it is difficult to measure Berkshire's businesses, how difficult is it to measure the “intrinsic value” of the United States economy of the Dollar? Given the shift of the U.S. from a manufacturing economy to an information/service economy, the measurement of trade and intrinsic value is as difficult as ever. For example, how does one take into account foreign investment banking services provided by Goldman, Morgan Stanley, or Merrill Lynch? Or folks who download software or subscribe to U.S. newsletters over the internet? How about Middle Eastern families who come to the medical center area in Houston every year for annual check-ups or to the MD Anderson facilities for the treatment of cancer? Rumors have been heard that the U.S. customs has a disingenuous way of measuring the value of software that is exported from the United States. Instead of taking the retail value and multiplying the number of units being shipped, U.S. customs are known to measure those exports by only taking into account the “intrinsic value” of the plastic and the wrappings of a particular software item. That is, instead of valuing a copy of Windows at $89 a copy, U.S. customs is only valuing that copy of Windows at $3 a copy at the most.
The Chinese and the Japanese may be working as hard as ever, but at the same time the highest echelons in those economies are squandering the populations' hard-earned wealth – as exemplified by the huge triple digit investment gains experienced by U.S. banks in China's banking system (where the officials will give an arm and a leg in order to do a deal with Goldman because it gives them “face”) and Morgan Stanley's trading gains in Japan (when it made millions of dollars in just one day by taking advantage of a Japanese firm's trading error). Moreover, U.S. shareholders still own most of the companies with the best global brand names today – and more importantly, the United States still has a virtual monopoly on the three most important sectors of the world economy – those being the technology/information sector (such as Google, Yahoo, Intel, MIT, Stanford, eBay, etc.), the financial sector, as well as the dominance of the world's media and entertainment services. The challenge going forward is to find ways to retain the “brand value” of the U.S. – and thus to continue to attract the best talent from countries such as China, India, Russia, and Western Europe. Our secondary education system may be in shambles compared to the Asian or even the British system, but the reputation of our collegiate system remains very much intact. Coupled with our business-friendly laws and with having one of the richest (and most receptive) consumer markets in the world, and there is no doubt that the U.S. is still the most attractive place to be for entrepreneurs all around the world. The challenge for the U.S. going forward is to find ways to retain these forces and momentum – and to make sure that the government continues to invest in fields such as nanotechnology and biotechnology. It is interesting to note that all these forces have combined to make Bill Gates and Warren Buffett the wealthiest two entrepreneurs in the world – and yet here they are bemoaning the prospects of the United States going forward. Sure, there will be challenges and obstacles right up ahead, but Americans have always found ingenious ways around those same obstacles. Does this author like the fact that a certain portion of our consumer sector is spending much more than they save (mostly folks who are in the working class and who earn less than the median wage in any given year)? No, of course not. But given the same situation in any other country, this author is willing to bet that consumer buying patterns will be very similar. After all, neither the Chinese nor the Japanese has a “savings gene” – they are only choosing to save in such amounts primarily because of their current economic circumstances.
Let's now turn to the stock and financial markets and touch up on several things. First, the Yen carry trade and the overnight announcement of the Bank of Japan finally ending its “quantitative easing” policy. Immediately subsequent to the announcement at 3pm local time, the Yen dipped – but it quickly reversed in the space of an hour and is now up 0.5% from yesterday's levels. Readers should continue to keep an eye on the Yen and the Yen carry trade. As I noted in our discussion forum, there is no guarantee that the Yen carry trade will remain in place even though the Bank of Japan is still keeping its zero interest-rate policy for now. Again, keep in mind that the current decline in commodities and gold is "reflexive" (as Soros labels it) in nature. That is, both the action in commodities and in Yen are dependent on each other. Some have argued that borrowing rates in Yen will still be effectively zero, and thus the rally in commodities should remain intact. What they ignore, however, is that the recent decline in commodities and in emerging markets may trigger margin calls for long-only funds. And since those folks have mostly borrowed in Yen, they will need to repay those loans in Yen - thus driving up the Yen in the process. As the Yen moves up, this will trigger more margin calls, etc, thus feeding on a vicious (for folks who are leveraged and short in Yen) cycle. Moreover, it is important to note that Japan – being in a current account surplus situation for virtually all its life – is not (unlike the U.S.) a “natural exporter” of currency, and given the end of its “quantitative easing” policy, there is a very strong chance that the hedge funds and the speculators could well run out of Yen to finance its long-only trades in the near future. In other words, there could be a HUGE MARGIN CALL in Yen at some point down the road.
Looking at the domestic stock market situation, this author is now seeing many similarities to that of the stock market during the topping out process in 1968 (which is a cyclical bull market within a secular bear market). Among other things, 1968 was the final year of a six-year bull market in small cap equities, and for the first time in history, commodity prices and inflation were rearing its ugly head in the United States in the absence of deflation in prior periods and the absence of a full-scale war (Vietnam not withstanding). While this author believes that the deflationary forces coming out of China and India still remains strong and that commodity prices should correct in the near future, I am nonetheless slightly troubled with the recent productivity and labor costs numbers. Europe was mired in a crisis, with the French Franc soon to be devalued as well as the British Pound. While no-one has recognized this yet, it should be noted that countries such as Spain and Italy are now running deficits after deficits. Spain, for example, is projected to run a current account deficit equivalent to 9% of its GDP this year. Italy is running out of money even as it has privatized many of its government-owned companies in order to feed its welfare system. Both of these countries have one thing in common to Argentina prior to its economic and monetary crisis back in 2002: they are both running huge deficits while being pegged to an overvalued currency. The only difference is that the currency for these countries is the Euro, while it was the U.S. dollar for Argentina back in 2002. Given the continuing dismal growth rates in Europe, its Europe's historic ability to disappoint GDP forecasters all around the world, and given at least a mid-cycle slowdown in the U.S., there is a high likelihood that the marginal countries in Europe (or Scandinavia? – think Iceland) will experience some kind of monetary crisis sometime this year or during 2007.
Another similarity was the huge, continuing proliferation of mutual funds subsequent to the bear market of February 1966 to October 1966. Today's hedge fund industry can be likened to the mutual fund industry back in 1968. After all, many of these are just glamorized long-only funds who choose to take positions in commodities, real estate, and international stocks other than positions in domestic equities. Just like in 1969 to 1970, I expect many of these hedge funds will be decimated (given tightening global liquidity, the extreme complacency, and a huge slowdown in hedge fund inflows) in the coming quarters – starting later this year or early in 2007. Ironically, I believe the best place to hide will be in cash – not only in cash but cash denominated in U.S. dollars.
Unlike the 1999 to 2000 topping out process where the NYSE A/D line topped out as early as April 1998, the current topping out process should be similar in nature to the 1968 topping out process, given that we were both at the tail-end of a bull market in small cap and mid cap equities. In other words, there does not need to be a huge divergence in breadth before we can conclude that the major market indices has topped. Case in point: The top of the October 1966 to December 1968 was marked by only a marginally lower high in the NYSE A/D line, as shown by the following chart courtesy of Decisionpoint.com:
As I have discussed before, this author is expecting the stock market to make a lower high and one final “blow off” rally immediately after the Fed has signaled it will stop hiking the Fed Funds rate. The key is to watch the breadth levels during such a rally. Should the NYSE A/D line make a lower high during that rally, then in all likelihood, the cyclical bull market that began in October 2002 would have officially ended.
Henry K. To, CFA