Goldbugs and Buffett
Face Major Dilemma
Rick Ackerman
May 5, 2004
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Poor Warren Buffett! What's
a guy worth $40 billion supposed to do with all that money when
the global investment climate just plain stinks? Some say he's
been a size buyer of Comex silver, and that merely by taking
delivery on his futures contracts he could instantly double the
metal's price. If true, he'd better do it soon, since, after
last week's bloodbath, silver could use a white knight. Spot
quotes have dropped 35 percent since early April, meaning that
if Buffett is actually sitting on silver, he has taken a savage
beating in the last few weeks.
Of course, we can't be certain
that he even owned any silver. But I'm not buying the argument
that the silver market is not big enough for players of Buffett's
size. Estimates place the world's stock at 150 million ounces,
or about $840 million's worth at Friday's prices. Although that
would represent only about 2% of his net worth, it does not necessarily
follow that Buffett would disdain silver any more than he would
the shares of a promising small-cap company with a 20-million-share
float. It all adds up, even the little $10 million crumbs.
Potential Minefields
Putting aside the matter of
whether the Sage of Omaha took a plunge in silver - or, according
to more recent rumors, bailed out of it - the question remains:
What is the world's most successful investor to do with such
a huge wad of cash? Or perhaps more to the point, what could
he -- or anyone else -- do with such a vast fortune? Or even
a small one? We can rule out the hot-money game for starters,
since chasing the asset-of-the-month just isn't Buffett's style.
Or is it? Not by design, for sure. But what if every place he
turned for shelter were to quickly become an investment minefield?
We can reasonably infer that
this is not a hazard Buffett is likely to have dodged, given
his well-publicized aversion of late for U.S. stocks and the
dollar. We should nonetheless give him the benefit of the doubt
on the performance of his stock portfolio, since the Dow Industrials
are trading only slightly lower than they were when the year
began. But with regard to the dollar, after having shifted a
reported third of his cash into foreign currencies, Buffett would
appear to have been in the wrong place at the wrong time, at
least since mid-February. That's when the greenback commenced
its strongest rally in nearly a year -- a rally that continues
to this day and which on Friday was spitting fire.
Exit Currencies Now?
So, does he pull out of currencies
now? And if the answer is yes, where should he park his billions
next? In REITs? Eurobonds? Commercial real estate? Asia? Or should
he shop around for a hedge fund that can handle a billion-dollar
client. The Catch-22 is that any asset manager with half of Buffett's
brains would also have the good sense to decline his billions,
since there are precious few sure things out there right now
in which such considerable sums can be confidently deployed.
A few months ago I would have
said that anyone diversifying out of dollars couldn't possibly
go wrong. But I'm not so sure now, and I will tell you why. My
reasoning is based on lessons learned during the twelve years
I spent on the options trading floor, and my speculative conclusion
has less to do with economics than with the sometimes extreme
irrationality of securities markets. Longtime subscribers will
know that I've been sounding a deflation theme for years, not
only in my newsletter, but in essays I've written for Barron's,
the San Francisco Examiner and other financial publications.
At the outset, I was inclined to think that a deflation-bound
economy - particularly a global one - would create the most challenging
investment environment imaginable And so it has. I have always
believed that deflation would bring, not money-making opportunities,
but rather a prolonged period of economic adversity during which
even the savviest investors would be challenged to hold onto
30%-40% of their original net worth.
Deflation Promises Few Bonanzas
I was laying it on a little
thick, perhaps, just to make the point. But not now; for if the
likes of Warren Buffett can get hijacked doing what is very arguably
the right thing, then what chance do the rest of us have of protecting
our nest eggs, never mind making a bundle? This is mainly because
there is no easy way to leverage a deflationary bust. If it were
otherwise, my friend Howard Hill, an expert's expert on the subject
of securitized debt, would have come up with a way to short the
residential real estate market with ten-for-one dollars.
It is absolutely crucial to
understand that deflation will not be dot-com mania in reverse.
There will be no penny shares whose value increases ten-thousand
fold, nor will there be pictures of "Deflation's Newest
Billionaires" on magazine covers. At best, as asset values
fall, the most astute investors will be the ones who can resist
buying the formerly $6 million Aspen ski chalet for $4 million.
They will have the imagination to see that the same house could
conceivably go begging for $400,000 before deflation has run
its course.
Gold the Perfect Hedge?
For many of us, the big question
is whether gold will prove to be the perfect hedge against a
deflationary bust that has been taking shape for more than ten
years. I had thought it would until recently. After all, I reasoned,
the U.S. dollar is already intrinsically worthless, and it is
therefore only a matter of time before everyone figures this
out and stampedes into tangible assets, especially bullion. But
what about deflation, you ask? Isn't cash supposed to be "king"
when incomes and asset values are falling? My stock response
has been that this deflation will be very different from all
the others: that it will be the first in history to have occurred
in a fiat-money world. The inevitable result would be a dollar
that finds its true value, falling to the threshold of worthlessness
as the price of gold soars commensurately. As for most other
classes of assets, they too will fall, seeking price levels tied
to their income value.
The no-brainer in all of this
is that the dollar can only go lower. This must be so, we see,
because the U.S. trade deficit is gargantuan and still growing,
the Federal budget is spinning out of control, and, in any event,
private, corporate and pubic debt have grown too large to service
without the help of a rip-roaring inflation. If we had Buffett's
money, then, we'd all probably have done what he did: diversify
heavily out of dollar assets.
'Worthless Dollar' Could
Surge
But Buffett - and millions
of other investors, most particularly precious-metals bulls --
could be very much mistaken in assuming that a weak or even worthless
dollar cannot soar, at least for a while, for reasons wholly
unrelated to its fundamental value. As a floor trader, I saw
this happen time and again when the shares of poorly run or even
criminally mismanaged company went ballistic. Many of them. after
initially falling for fundamental reasons that were widely recognized,
soared 30% or 40% in mere days. The cause almost invariably was
unrelated to the company's fortunes; rather, it was the result
of egregious, fleeting imbalances between supply and demand.
The demand came from shorts who, having bet the stock would fall,
were stampeded into covering their positions when the stock started
moving against them. As for supply, it dried up almost completely
when shareholders realized they had the bears on the ropes.
I have seen this occur on the
trading floor too many times to ignore the possibility it could
happen to the dollar. As I explained here recently, most of the
world's hundreds of trillions of dollars of debt is denominated
in dollars, and this debt represents, implicitly, a massive short-position
against the dollar. As such, all borrowers of dollars should
be praying for inflation, since it would allow them to pay back
what they owe in cheapened money. They could also pray for the
one other thing that might do the trick - a dramatic rise in
incomes over and above the rate of inflation. Miracles do happen.
Murphy's Law and Debt
But unless Murphy's Law is
suspended for the next ten years, we can be reasonably certain
that borrowers are not going to get off quite so easily, especially
since all it would take to crush them is a rise in lending rates.
I'm not talking about 15% mortgages, either, or even 10%. If
residential property values and incomes were to fall even slightly,
a five- or six-percent mortgage would for most homeowners become
a crushing burden.
This is the very crux of the
coming deflation as well as the basis for a potentially sensational
rise in the dollar that almost no one expects. As a mechanism
to cleanse the economic system -- to cleanse capitalism,
if you will --- the scenario has the "virtue" of outfoxing
not only gold-bugs who trust that the dollar's inevitable decline
will make bullion far more precious, but also financial world-beaters
like Warren Buffett, who perforce do not come naturally to the
notion that cash may be the best asset to hold for the next several
years.
Dilemma for Goldbugs
A strong dollar - one impelled
by uncontrollable market forces rather than by Fed whim - seems
the most likely catalyst for a deflationary collapse, albeit
the one least expected. What it implies is dollar rates rising
to extraordinary levels in real terms, with foreign money pouring
in to take advantage. If this should come to pass, there will
be a dearth of double-your-money bets, and even financial wizards
like Warren Buffett will be challenged to withstand the violent,
tidal shifts in asset values. For gold bugs, such a volatile
period would pose a particular dilemma, since bullion's eventual
rise, though absolutely assured, would come only after the pain
of deflation had caused the central bank to shovel money out
the door. Meanwhile, we should not pretend to be mystified if
the dollar's supposed bear rally steepens and bullion remains
leaden. A "worthless" dollar may yet have the last
laugh on all those who have rightfully disparaged it.
***
Rick Ackerman
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