Sell risk, buy caution. Sell complexity, buy simplicity...
THE ERA OF PEAK GREED is now ended, the Era of Caution is upon us, said Eric J.Fry of the Rude Awakening at Agora Inc.'s recent Vancouver Summit.
That's not such a bad thing. Caution sounds boring, but it's not nearly as boring as it sounds. In fact, I think being cautious is kind of an uncelebrated virtue. It's a little bit like being free of venereal disease. You can't really brag about it at a cocktail party, but it's still a pretty darn good thing at the end of the day.
To illustrate the virtues of caution, let me cite the example of Warren Buffett. There's a story that you might know about him. Buffett operated a partnership from the late 1950s until 1969. During those 13 years that partnership delivered almost a 30% annualized return and made him his first $25 million.
What some of you might not know is that he just shut it down one day. He said that he couldn't find any investing opportunities that appealed to him. So he just shut down the partnership and sent the money back.
"I didn't know how to be a hero anymore," Buffett said at the time. "I had been a Niagara Falls of new ideas. But I became an eyedropper."
Not knowing what to do, he did nothing...and that was brilliant.
This is a slide I showed last year. In fact, I ended my speech here in Vancouver last year with this quote:
"Risk comes from not knowing what you're doing."
– Warren Buffett
I think this quote is more germane still in 2008. In an era of caution, you want to make sure you know what you're doing. As it turns out, it was very important to HAVE known what you were doing twelve months ago.
The Era of Peak Greed was not so much an era of greed, in fact. It was an Era of Peak Stupidity. Lots of people did lots of stupid things. Not just that, they leveraged up their stupidity. So American finance companies embarked on a frenzied borrowing binge and they levered up big time in order to fulfill their corporate mandate, which was to maximize returns to management.
Here's how bad it got. I was at a Grant's Conference in New York in April, and David Einhorn spoke. He's been in the press a lot lately for being negative on Lehman Brothers. And he said: "A few weeks ago, the financial world was presented with the imminent failure of Carlyle Capital Corporation. It had leveraged itself more than thirty to one. The press scoffed about what kind of insanity this was. Who in their right minds would take on such leverage?"
Well, as it turns out, no one in their RIGHT minds would take on such leverage, but everyone on Wall Street took on that kind of leverage. Every investment bank was leveraged more highly than Carlyle, against assets that were inferior to Carlyle's.
So somehow, these highly leveraged balance sheets, offset by various versions of toxic waste, passed for normalcy, passed for prudent investing, passed for prudent stewardship. Everyone was doing it.
But it turns out that operating an insanely leveraged balance sheet is not such a good idea. It turns out that leverage is not a great thing at all in extreme applications...and all of this leveraged stupidity of the last several years was nurtured by the ratings agencies. By Moody's primarily, and by S&P.
The analysts at Moody's, despite all their advanced degrees, and their whiz-bang quant models, weren't any more capable of determining the credit-worthiness of a Collateralized Obligation [CDO] than a monkey with an abacus. They were unable to quantify what was essentially non-quantifiable. The stuff was just too complicated.
That's why I never bought a CDO...not knowingly, at least...and that's why I was afraid to buy a banking stock. I just wasn't smart enough to buy a banking stock. I always kept Buffett's phrase in my mind that "risk comes from not knowing what you're doing."
To illustrate that point, I also presented this slide last year. It's from Chuck Prince, the former CEO of Citigroup:
This quote is one of the most remarkable mementoes of the era. Prince uttered these words just a few weeks before last year's Vancouver conference and he was booted out within three months.
I displayed this quote last year and I said, "This is all you really need to know about Citigroup. This is all you need to know about finance in America. This quote!"
And that's why I urged people one year ago to avoid financials and that's why I urge people now to avoid the temptation to bottom-fish in this sector...unless you REALLY know what you're doing. There's still too much complexity; too many unknowns; and too much downside, potentially, remaining.
I would refer to this recent quote from Charlie Munger: "Include me out!...A lot of rot has crept into the financial system. We've got a lot of scandals coming."
This is why we are now entering the Era of Caution – not because of what happened during the last twelve months, but because we do not know what will happen during the NEXT twelve months.
What we KNOW is that we are in a period of de-leveraging. DE-leveraging. We are going to reverse what has been happening for the last several years. And this de-leveraging will occur at every level. It will occur in the derivatives markets; it will occur on personal balance sheets; and it will occur on financial balance sheets.
America lives on credit and without it, we will have a hard time. The hard time will be even harder than normal because we have already piled up liabilities that we now have to deal with. The banks are struggling to deal with them. So are a lot of individuals.
Here's another wonderful quote from Charlie Munger: "One thing about accounting, the liabilities are always 100% good."
So we've got to pay off the liabilities, but without any new credit. That means banks will sell whatever they can, including parts of themselves. Individuals will sell whatever they can, including the roofs over their heads. And both of these activities will depress asset values. We Americans are prepared for no such thing.
We're dressed in string bikinis, financially speaking. And I'll admit, I love string bikinis. But I don't wear one very often, and I certainly wouldn't wear one on a polar ice-fishing expedition.
This image here is not simply gratuitous. It is also the approximate economic model of modern America:
Look good until you perish.
So what do we do? There are a lot of ways to describe the same general idea. I'll mention a few of them:
Sell risk, buy caution. Sell complexity, buy simplicity. Sell the beneficiaries of discretionary spending, buy the beneficiaries of necessary spending.