Sunday, March 1, 2009

The Oracle Speaks

When Warren Buffett speaks, people listen.  And his most anticipated pronouncements come in the Chairman's Letter portion of Berkshire Hathaway's annual report, which was released yesterday.  There are already lots of comments in print and on the web from various experts offering interpretations of the letter.  In the true spirit of Yet Another Investment Opinion, I decided to (briefly) share mine.

Treasury Bonds 

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary".

This comment by Buffett will produce some interesting macroeconomic research reports tomorrow morning from the brokers and research shops.  Many of the most ardent bears on the economy have insisted that treasury bond levels are not due to a bubble, but rather to the high demand for secure income in a risky and deflationary environment.  It will be interesting to see if anyone has the guts to say that Warren is wrong (perhaps he is, but will anyone challenge him?).

Here's why you should care:  First, many other bonds are priced relative to treasuries.  Most municipals and good quality corporates are priced by observing the rate for a U.S. Treasury of similar maturity and then adding a spread.  For example, you could buy a treasury note with a five year maturity  and a yield of about 2.00%.  A similar maturity corporate bond like the newly issued Chevron 3.95% offers a yield of about 4%, for a spread of 2% (200 basis points)  A good quality tax-exempt municipal bond might yield 2.25%, or a spread of 25 basis points.  While both of those spreads are extremely high relative to their historical levels, the yields themselves (4% and 2.25%) aren't particularly unusual.  

Bond bulls will tell you that you should buy bonds mostly because they're very cheap.  But they're only cheap because of the wide spreads.  Since 1980, that five-year treasury yield has ranged from 16% to just over 1% with an average of around 7%.  Now I'll quickly admit that today's economic situation is very different from that of the early 1980s.  And good quality bonds in short maturities are very suitable investments for risk-adverse portfolios.  However, if Buffett is right about the treasury bubble, when the bubble pops those corporates and munis aren't going to look nearly as cheap.

Municipal Bonds

Buffett notes that, while historical default rates for munis have been very low, it's likely that they'll get much worse.  His point is primarily about the influence of insurance on default rates, and I'll leave it to you to read if you're interested.  However, he comments on pressures facing municipalities:

"Local governments are going to face far tougher fiscal problems in the future than they have to date.The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering."

Finally on munis, although it's not a Buffet point:  Munis are bought by rich people.  They help rich people avoid taxes.  Take a look at the Obama budget plan and think about how tax-avoidance plans for rich people will be treated in coming years. 

Interest rate risk, credit risk, and political risk.

I don't want to seem to be overly bearish on bonds.  But with the stock market down 50%, I see lots more opportunity in equities.  Sure, you can lock in low single digit yields in bonds.  But I'm betting that over the next 5 years, stocks will do substantially better.

Portfolio Update

I added to my DuPont position on Friday.  Current holdings:  ABB Limited, Boeing, Caterpillar, Cisco, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter&Gamble, Slumberger, Sysco, and Walgreen.


  1. No comment on GE's dividend cut?

  2. good question. It was interesting to see that, when the news of the dividend cut broke on Friday afternoon, the stock initially spiked up but then settled back to close within pennies of where it was before the news hit. That tells me that a dividend cut had been fully priced in and was well expected. Same is probably true of a ratings cut. I'll probably look to tiptoe into more GE in the coming week. However, it's sort of an outlier in my portfolio (like NYT) because of its questionable balance sheet.

  3. I was speaking about your blog with a friend of mine, and she brought up a good point -- when you talk about entering new positions, are you putting cash to work or are you re-allocating assets away from other investments like mutual funds, other stocks, etc?

  4. the portfolio moves all represent moving cash into stocks. they're real investments of my own money in one specific account (not some paper or theoretical portfolio). Here's what I wrote on Jan 4:

    "I'm currently about 33% invested in my high-quality portfolio, with the balance in cash. I've been looking for a chance to add to those positions and start a few others, but the market's runup in the past two weeks has taken most of them beyond my target buy points. If the market goes straight up from here, I'll miss an opportunity (although I do have more equity exposure in my retirement accounts). If a new bull market has already begun, I'm willing to take the chance that I'm underinvested. I could easily see more downside, and real losses are more painful than missed gains."

    Since Jan 4, my equity allocation has risen from about 33% to probably the upper 40s. I'm intentionally not being too specific because I don't want to get into the quarterly performance vs benchmark game. My idea is to buy good quality stocks on (plus an occasional GE or NYT)on weakness and hold them for three to five years. Anyone who follows this blog over time will be able to get a very good idea of how my stock selection has worked out.

    Hope that helps.