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Good news, bad news and the $3.5 trillion net

Ray Unger  —  5/01/2008 5:15 pm

Those $600 checks we're about to receive from Uncle Sam (the good news) won't be enough to offset the continuing shockwaves from the real estate debacle (the bad news) anytime soon. Thus, the length and depth of the recession that economists are now just starting to acknowledge is far from known. So where does that leave investors?

Before we get into that, let's hear from a few old sages who've certainly earned the right to say, "been there ndsh done that." Regarding the mortgage meltdown, no one's been more prescient about this than multi-billionaire manager extraordinaire Warren Buffett. In the April 28, 2008 issue of Fortune Magazine (see "What Warren Thinks ") Fortune writer Nicholas Varchaver chronicles a multi-day bull session Warren held with 150 students from the University of Pennsylvania's Wharton School of Finance.

During this Omaha summit Warren held court on all manner of subjects -- how he finds investment ideas (he reads a lot), the inefficiencies of the market, the cost of regulations such as Sarbanes-Oxley, and the monumental mess created by collateralized debt obligations (CDOs). This last subject, in particular, needs some "granularity." That's a fancy Wall Street term for more details.

Suppose all your neighbors refinanced their home mortgages with one lender. Then that lender put those mortgages into a package and sold that package to another lender. In essence, that's a CDO. Now such instruments are not inherently bad -- they allow investors to earn interest on home mortgages without the messy job of originating loans. Unfortunately, when the CDOs got too large and complex, they began to unravel when homeowners couldn't make their monthly payments. The reversal of fortune of these debt instruments is the root cause of our economic malaise.

According to Buffett, in 2006 homeowners were able to raise $330 billion in cash -- to buy other things - by refinancing their homes. That's not happening today. In fact, we're seeing homeowners accelerating their mortgage payments -- as Buffett says, "a mortgage industry that's deleveraging." Such deleveraging reduces personal consumption and GDP.

Now let's switch to another old sage, 89 year old Peter Bernstein. His 1996 book, "Against the Gods: The Remarkable Story of Risk" seems appropriate to our current situation. In a recent interview (see "One Guy Who Has Seen It All Doesn't Like What He Sees Now", by E.S. Browning, April 26, 2008, Wall Street Journal) Bernstein sees two culprits preventing us from a V shaped economic recovery. Like Buffett, he cites the abuses created by the securitization of debt (home mortgages), and years of over borrowing. As a result he postulates that, "we are going to have an extremely risk-averse economy for a long time."

In essence, neither sees a short and shallow recession ahead, but a more protracted and extended period of weakness. So should investors sell? Not necessarily. Buffett and Bernstein's admonitions, you see, may have already been heeded.

During a recent conference call, Milwaukee-based Heartland Funds showed a graph depicting cash in money market funds since 1980. They noted the peaks in cash during the troughs of the market. Today, we're at one of those peaks. According to Investment Company Institute figures, April money market mutual fund assets are at record levels -- $3.5 trillion. That compares to $2.4 trillion in December of 2006.

This dovetails nicely with Peter Bernstein's assertion that today's investors, by and large, are now more risk-averse. And it could explain why the market indices have been so range bound since October of last year. Investors are wary of over-paying for a stock, but with all the cash available, they're not afraid to pick up a bargain when the market declines. That keeps the market from penetrating previous lows.

I must admit that I'm excited by this new risk aversion. I can't recall when so many good investment ideas ndsh more on these in later columns ndsh have come to the surface. We now have time to evaluate them without some hedge fund manager pushing the stock to unsustainable highs. And we have a safety net of sorts ndsh the $3.5 trillion cash horde sitting in money market funds -- that keeps the market from falling too low. Such an environment doesn't bode well for instant profit but it does give us an opportunity to invest in some great stocks for the future.

Ray Unger  —  5/01/2008 5:15 pm