I don’t usually write on macro topics; however, I do get lots of emails asking me about the economy, markets, etc. I try to respond to these emails. Here are some excerpts from an email response I sent out tonight (some of the following has been edited):
The Fed is in a very tough position. This is a credit problem. It’s serious. It’s hard to say what the result will be – but it could potentially be very bad. You can have some pretty catastrophic things happen when people start to panic – as far as what happens with money and how all sorts of things can seize up at once. It’s really a psychological problem – a spiral of negativity and panic that feeds on itself. People start to do irrational things and then others respond in irrational ways to their irrational actions and so on and so forth.
The possibility of terrible outsized effects from the kinds of problems we’re seeing with Bear Stearns etc. is real. The housing problem is real. The economy can deal with a lot of things clogging up the system, but credit is probably the toughest.
This is the most serious threat the economy has faced in a long, long time – much more serious (to the economy) than the September 11th attacks. People always want to see just one catastrophic event – point to that – and explain away horrible problems. It doesn’t happen that way. You have a whole climate of negativity, fear, panic, etc. that feeds on itself and causes real problems. It really does come down to psychology. And it’s amazing how fast it can happen.
It’s something that either achieves a sort of critical mass or it doesn’t. It’s like a riot. Either it never really gets out of control and we all forget about it, or it builds on itself and it gets bigger and uglier faster than anyone could imagine.
I don’t worry about single issues. The price of oil alone means next to nothing. Housing alone means something, but it’s really how housing indirectly influences everybody’s behavior where you get problems. A stock market crash means next to nothing to the economy. But the totality of some combination of these things – the climate created – that means everything.
We are on the brink. We haven’t seen such potentially perilous economic times in a long, long time. But if the peril passes no one remembers it. People remember 1929 because the peril didn’t pass – because that climate of depression fed on itself in so many horrible ways that things got worse and worse not better. It seems almost inevitable in the past – but there was a point (no one knows when at the time) where you were on the brink, where terrible things lasting a long, long time could have happened (and eventually did) where you could have broken a downward spiral.
People always want to look at just one “black” day and …
In finance, liquidity is not a physical state it is a psychological state. Liquidity is a state of mind. Worse yet, liquidity is in the eye of the beholder. That is not merely to say that liquidity is subjective. Liquidity is subjective, but it’s also more than subjective – it exists in the minds of others – others who can and do transact business with you. So liquidity is – to a great extent – uncontrollable.
Good assets may not necessarily be liquid assets. As a result, good decisions do not necessarily lead to good outcomes when an actor is dependent upon liquidity. An actor is dependent upon liquidity whenever liabilities are great relative to assets. However, an actor can avoid insolvency and make good decisions that will almost certainly lead to good outcomes if the actor can studiously avoid disbursing cash or other assets to meet obligations in the near-term. An actor who can finance an asset by selling a thirty-year zero-coupon bond does not have to worry much about liquidity. Any actor so financed weds its destiny almost entirely to the intrinsic value of the asset – and only the intrinsic value of the asset. All other worldly concerns seem to melt away. This sort of financial nirvana is rarely achieved by any actor who has tasted of the sweet, sweet nectar known as debt.
Actors – like addicts – can develop a dependence through regular use. There is no such thing as non-habit forming debt. Debt is so addictive precisely because it is so useful.
Wonderful businesses have been brought down by a lack of common sense and an abundance of debt. Great businesses – even some simple, great businesses – have been brought down by debt.
What their competitors could never do to them, these great businesses did to themselves.
Berkshire Hathaway (BRK.B) bought Fruit of the Loom out of bankruptcy. It’s hard to bankrupt an entrenched underwear business. Only debt could kill a business like Fruit of the Loom or Hanes (HBI).
So how can investors evaluate a debt-laden liquidity whore? For the most part they can’t.
Investors never like to hear that. But it’s true.
Hanes may have debt; but at least its business isn’t directly dependent on liquidity. Like Fruit of the Loom, Hanes can go bankrupt, but Hanes can also be evaluated without reference to all sorts of variables beyond the company’s control. An investor can decide if the company has too much debt without giving much thought to capital markets, interest rates, commodity prices, and all the other much discussed macro variables. The further an investor ventures from the specifics of the business he is evaluating the more unstable all of his assumptions become. As he stacks unstable assumption upon unstable assumption, he builds a teetering tower crowned with an intrinsic value estimate that could prove perilous.
If you can make successful macro bets, make them. If that’s your strong suit, stick with it. But don’t confuse the business of …