Cancer and Random Gleanings

Mr. Market (the idea preached by Sir Graham) and later from the letters of Sir Buffett is clearly at an irrational level. I don't say this because I try to time the market, but rather because there are little to no opportunities to buy a business at a discount that guarantees a margin of safety. Fortunately for us (individual investors) we have three options: 1)Buy, 2)Sell, 3)Do nothing. Some people with great reputations as investors are clearly concerned, this includes the likes of: Jeremy Grantham, Sir Buffett, Prem Watsa, Wilbur Ross, and a plethora of other "smart guys."


Imagine for a moment that you go to the doctor for a routine check-up only to find out that you have some type of cancer, at this point it is life or death. The doctor assigns you to a specialist for you type of cancer and you are given a maximum of six months to live. Three months passes, now fourth, and on to the sixth and you are still alive. Because you are alive doesn't mean that you have beat cancer, it is still a life or death issue, but to the average person, the longer you live, the higher odds that you have beat cancer. There are many fallacies with this logic, but nonetheless, it is still a coin flip result, head-life, tails-death, or vice versa.

I use this thought process to better understand the market at critical junctions, it makes a great deal of sense to me. Many of these smart guys that I mentioned above have remarked of the lofty, excess levels before this year started. Because, none of their predictions have come true does not mean that the market has beat cancer, it is still a concern. The more things change, the more they stay the same, no matter how willing present financial architects are, the math is the same. Leverage is still a financial catastrophe waiting to happen.

"Liquidity is ultimately a coward. There's always too much when it's least needed and it's nowhere to be found when needed the most."


The two requirements for any bubble: 1) Excellent economic fundamentals, 2)Large amounts of liquidity leading to high levels of leverage. According to the above quote, high liquidity leads to higher levels of leverage, and this isn't marginal, it is exponential. If you are 1-to-1 and suddenly because of high liquidity you are able to have 2-to-1, you have greater exposure. I will not tamper with the idea that we have excellent economic fundamentals, but I don't think that many of the economic indicators used by Wall Street to gauge Main Street are transparent. We are first a service economy (70%) and second a manufacturing, yet many Wall Street indicators are manufacturing based. (as a side note: I am really excited about next weeks blog because I will touch on the many meaningless, yet manipulated economic indicators.)

The only thing I have ever learned in relation to the U.S. economy is to Never Underestimate the U.S. Consumer. I learned this lesson the hard way and I sincerely believe that once you understand/appreciate the statement above, you will have mastered the subject of economics. The (U.S.) consumer is The primary force behind growth in the economy and sustainability. The three funding sources on tap from the consumer are: 1)Rising income, 2)Debt expansion, and 3)Saving liquidation (Williams, John). Lets step back and look at each of these sources of consumer growth.

1)Rising Income- At the higher end (top 20%), I don't think this is a problem, but the lower end of the bracket is clearly feeling some pain. Rising gas prices, energy, food represent a higher percentage when the denominator stay the same.

2)Debt Expansion- This is probably one of the harder elements of this puzzle to gauge. However, having been an intern at a Credit Card agency for two Summers ('03 and '04), I can tell you that the balloon is at a critical point. Meaning, I don't think it can expand anymore. And while we are on the topic, the talking heads on Wall Street use this excuse that I would hate for anyone to be fooled by. The conventional wisdom now-a-days is "Corporate balance sheets are flush with cash" which is true, but the rebuttal is that Consumer balance sheets are flush with debt, that is my argument. Most of the cash on corporate balance sheets have strings attached to the footnotes on their annual report, so I don't buy it.

3)Saving Liquidation- Probably the only oxymoron in this post, don't laugh. One source of untapped economic growth for China is savings liquidation because of their high savings rate (50%). However, if our trade deficit and budget deficit say anything about our saving habits, it is that we are non-believers.


Having analyzed these three integral parts behind growth in our economy from the consumer, I am still unwilling to bet against the consumer and that says a lot because logic and common sense is at odds.

Next, as a value investor I don't really care about the market indices, as long as I find value, concerns are unwarranted, but that doesn't mean that I should be oblivious to certain flaws. Currently, Financials represent a little over 20% of the S&P 500, with I.T. another 15%. I think that the financials could really feel some pain in the coming months and this isn't a forecast, I'm willing to go out on a limb and make it a guarantee. I think their models, based on credit spreads are not weighing the risks of credit contraction with enough emphasis. There is also that subprime mess that has been checked off as a non-concern, but with Mortgage rates rising, will be a problem. As of today, 82 lenders have imploded. So, yes, it is a concern.

The only CEO from a major bank that I respect and trust is Richard Kovacevich from Wells Fargo, (and I think he deserves an entire post!) but he had this to say in December '06, "I am not a forecaster of the future; I'm a historian. And history says this will blow up. It always has. And there will be some blood on the street." Now, I want you to do an exercise, get a sheet of paper and list the CEO's who would say something like this and still keep their jobs. Sir Buffett has great respect for Mr. Kovacevich, and I should say it is warranted. It doesn't take a genius to make a prediction about the financial sector with Richard on your side.


Finally, just because Mr. Kovacevich's prediction is 6 months due, does not mean the cancer is cured, in fact high chance that it has reached more excessive levels. Personally, I want to see some volatility because I am itching to buy at discount levels not seen today.

(Disclosure: I do not own any shares of WFC)

I hope you enjoyed the first installment, please e-mail me with any suggestions.


Thank you,

S.K.