Wednesday, April 8, 2009

Clearing The Forest

"These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood."
Clemenza,  The Godfather

Many things in markets and in the economy move along a steady long-term trend, but that doesn't mean they stick closely to the trendline.  Instead, we experience a cycle of overshoot and undershoot.  

Until recently, the top graduates of the top colleges and business schools overwhelmingly pursued jobs on Wall Street.  Overshoot.  When I graduated from business school, the hottest career was consulting. Ten years ago, everyone wanted to work for a dotcom.  Now I hear that law schools are seeing a big increase in applications.

That's a common phenomenon.  An industry, or a career, or a location, or an investment opportunity gets "hot", and people pour in.  Basic economics:  capital, including human capital, flows to the areas of highest returns.  Of course, as more capital flows in, returns get diluted and often turn negative.  Lower returns reduce the capital inflows.  Capital becomes scarce. Lather, rinse, repeat.

For much of modern economic history, the business cycle has oscillated between boom and bust. Periodic recessions served to balance inventories, labor, and other supply-demand factors. However, until recently the US economy had gone for almost twenty years without a recession (the brief 01-02 hiccup doesn't really count).  As a result, a thick underbrush built up in the economic forest.

So as painful as this current recession is, it's part of a healthy and necessary cleansing process. When we eventually emerge from it, we'll find many beneficial effects.  Consumer balance sheets will be significantly better.  Excesses in industries like housing and autos will have been purged. Business bankruptcies, as painful as they are to owners and employees, will allow the survivors to become healthier and more profitable, and will sow the seeds for new entrepreneurs.  Job losses will eventually become job gains, and will provide new opportunities for a new generation of workers.

Investment opportunities follow a similar cycle.  I have previously quoted the aphorism about how bear markets return stocks to their rightful owners.  It's painful to watch the decimation in your 401k.  However, by the time this is over you'll have an opportunity to acquire stock in some truly outstanding businesses at once-in-a-generation prices. 

Buffett and others have often commented on the curious behavior of investors, who collectively seem to prefer to pay high prices and avoid low priced merchandise in the stock market.  Don't obsess over the past.  Be glad that we're heading toward a time of great opportunity-- opportunity for entrepreneurs, businessmen, and investors.  Will you be ready?


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