Is It Different This Time? Part 4

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
 
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.

In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.

Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”

“And how long will it last? It could be very long indeed.”

Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.

That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.

In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”

Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.

That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)

In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

But here is the seeming paradox. What is Buffett doing?

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

Since no one can forecast the short term direction of the stock market, Buffet continues:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

This is my fourth post in the series called Is It Different This Time?  Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.

photo credit: notsogoodphotography