Mr. Buffet’s Market Call

Oct 27, 2008 – In an article published in The New York Times on October 16th, Warren Buffet tells us that he has “been buying American stocks“. He has one of the best performance records of anyone, and has generated stunning investment results over the past four decades. For this reason, we should take notice of what he is doing.

Mr. Buffett’s reasons for buying are summed up in the following comment: “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. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.“

In all likelihood, he’s right of course, but he warns: “Let me be clear on one point: I can’t predict the short-term movements of the stock market.” Clearly, Mr. Buffett is a savvy investor and buys bargains when he sees them, which apparently is right now. But just as clearly, he is focusing on the long-term.

In explaining this inability to predict short-term movements in the stock market – or perhaps his indifference to them – Mr. Buffett refers to history to make his point. “During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend.“

The moments in time he chooses are interesting. With the benefit of hindsight, we know that they were important turning points. I have numbered these three moments on the following chart, which presents the month-end price of Dow Jones Industrials Average measured in weights of gold.

Mr. Buffett’s three turning points have a common thread. As we can see from the above chart, all of them are near the green horizontal line, a marker denoting that the DJIA was relatively cheap when measured in terms of gold’s purchasing power. The DJIA was 64.4, 84.7 and 40.0 goldgrams at points 1, 2 and 3 respectively. Keep in mind too that these are month-end prices. During these months, even lower prices were reached.

In comparison, the price of the DJIA at September 30th in the above chart was 384.6 goldgrams. As of October 16th when Mr. Buffett’s article was published, the price of the DJIA had fallen to 348.5 goldgrams, which is still approximately the same price as I write.

Clearly, from this perspective, the DJIA is not as good a value as it was at the three turning points referenced by Mr. Buffett. So perhaps Mr. Buffett is focusing on certain undervalued stocks which he doesn’t name, and not the broad averages. As the old saying goes, it is a market of stocks, and not a stock market. Any average like the DJIA or S&P 500 cannot possibly identify those individual stocks that today may offer exceptional value. After all, Mr. Buffett does warn us that “investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.”

Nevertheless, it is reasonable to ponder whether Mr. Buffett is making his market call too early. In fact, when prices are viewed from a gold perspective, it seems he may be way too early. But there is another important observation made by Mr. Buffett in his article that further explains his thinking.

“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.“

This paragraph makes clear that Mr. Buffett is looking at the stock market solely from a dollar perspective. He is in effect, telling us to own stocks instead of dollars, which is I think good advice given the way the dollar is being rapidly debased by being created at extraordinarily high rates and at levels that far exceed economic growth. Also, the interest one can earn on dollar denominated assets is far less than the inflation rate. In other words, as Mr. Buffett notes, the dollar is “a terrible long-term asset…that pays virtually nothing and is certain to depreciate.”

So from the perspective of the dollar, stocks are the better choice. But in my view gold still remains the better alternative, which is a point of view that I have held for several years. See for example, the following three articles that I have written and posted on this site:

May 15th, 2006 – Hold Gold, Not the Dow

October 4th, 2006 – Gold Is Still the Better Choice

June 4, 2007 – What New Record?

In summary, there are times to be in stocks, and times to be in cash. Right now cash is the better choice, but not dollar-cash as Mr. Buffett warns. Stocks are cheap in dollar terms. The Dow industrials finished last week at a new closing low for 2008, as did the Standard & Poor’s 500 index. So far this year the DJIA is down 37% while the S&P 500 has lost 40% and the Nasdaq 41%. At these price levels, Mr. Buffett advises that stocks are a better choice than dollars, but in my view, stocks are not yet a better choice than gold. If history is any guide, and I believe it is and so does Mr. Buffett given that he used historical examples, the price of the DJIA measured in terms of gold has much further to fall.

Consequently, investors should stay out of the DJIA and other major indices while they continue to hold gold, thereby keeping their money safe and sound until stock prices fall to more reasonable levels when measured in terms of gold.