Looking Beyond the Panic

Warren Buffett may have been way too premature when he declared in May of this year that the panic phase of the credit crisis was over. Recent developments suggest, however, that there are good reasons to conclude that Mr. Buffett's prediction is close at hand. Evidence for this thinking can be found in two items posted in today’s media.

The first is the Financial Times commentary by George Soros (“Recapitalise the banking system”*), which is a must read for all investors interested in understanding key aspects of the next steps in the credit crisis. The second is the simply awful results of the latest ISM manufacturing report.

With the near certain passage of the sweetened Senate bill, the Soros commentary may strike some as moot, for the Soros prescription will never go beyond the eyeballs of its readers. Such thinking, however, would miss the nuggets of insight embedded in his views. Of special note is how mark-to-market for illiquid assets will die its deserved death. For example, Soros’ recommendation “could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated based on the Treasury’s cost of borrowing. Mortgage service companies…could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.” In other words, valuation will be (and in fact is being) determined not on the capital requirements of impaired banks but on the US government. This is, in effect, the same valuation result that will occur under the Paulson plan (see section 132 of the House bill) and the announcement of the SEC and FASB made yesterday re fair value and FAS 157. Bye bye, fair value. Hello, common sense.

On the assumption of passage of the Senate bill by the adults in Congress, the pressure on the House will be enormous, made all the more difficult to resist considering the extension of the business tax breaks (in the Senate bill) and today’s dire ISM manufacturing report. The business oriented realists in the House will hopefully make the connection.

Investment Strategy Implications

The financial markets are not out of the woods. But with the full faith and credit (and the attention) of the US government now fully engaged, it does seem fair to conclude that Warren Buffett’s premature prediction will now come to pass. If so, then it’s time to look past the panic and examine the economic debris that the unnecessarily disorderly deleveraging process has wrought. In that regard, it can be assumed that overall operating earnings will decline moderately thanks to improving financial earnings (write ups!) offset by a substantial decline in the more cyclical sensitive sectors (consumer balance sheet repair via deleveraging). In the process, P/E ratios will likely continue their descent below their long-term average of 15x, but not into the deep recession zone of 8 to 12x. The near term effect should be a sense of relief for investors as the panic triggered by the credit crisis slowly recedes.

(Oh, did I mention the fact that the fourth quarter tends to be a very good one for stocks?)

*To read the Soros commentary (subscription required), click here