Gustavo Ballvé on August 9th, 2011
Food for thought, Home, Mental models, Portfolio Management, Risk management, Signal or Noise

After such a strong sell-off in global markets – after a series of smaller sell-offs in the preceding days – there’s one vital thing that can be said to investors (as per the Graham differentiation between investors and speculators): “don’t panic”. We’ll offer more: “Think long-term”. “Buy when you hear cannons, sell when you hear violins”. “If you’re a net buyer, you should want prices to fall.”

Any investor has read such words before, from people much wiser than ourselves. Guess what? It’s still true. We take a look at the downgrade of the US debt and try to provide, through several stories, some perspective.

First of all: what really happened? The S&P ratings agency downgraded the US debt one notch, from the highest possible rating, the famous “triple A”. As we always stress: read the primary source. What does the downgrade mean, really? As the S&P CEO said on television quite desperately after tons of interviews, “it just means that the US debt is a little riskier on a long-term basis”. It doesn’t mean that America is broke, that it is in a recession, that it can’t borrow anymore. It means that it’s in a dumb, dangerous path – nothing investors didn’t know before the downgrade.

So, does everyone agree with S&P’s decision? No – not even the debt market. Obviously Tim Geithner would say he thinks it’s dumb, and he has, but he’s biased. Warren Buffett and Bill Miller have said they disagree with it, but they’re still biased. Plenty, plenty of other opinions agreeing and disagreeing with the S&P have been voiced and written and can be Google’d in no time.

Next question: Does the S&P have a consistently flawless record of success for its ratings? No. No one has a flawless history of investment opinions. We wouldn’t call them worthless either, but this has clearly become a battle for credibility in which both sides don’t really have much to show for them – but both have much to lose. As for S&P and credit raters in general, it wasn’t long ago that the 2008 crisis nearly destroyed institutions that had been AAA up until the last moment. Anything they say is to be taken with salt. However, anything anybody says should be treated with the same intellectual skepticism.

More: Does the S&P action dictate that pension funds/ insurers/ China must sell its US Treasury debt positions right now? No. However, should a second of the three main ratings (the others being Moodys and Fitch) downgrade the US debt, that could trigger “automatic” selling by entities required to hold a certain portion of certain assets in AAA securities. Both Fitch and Moodys have said that they have no plans to downgrade the US debt anytime soon. Is that a guarantee? No. Can they change their minds if the S&P’s actions turns out to be a self-fulfilling prophecy? Yes. Should the US debt be downgraded if the country continues to behave recklessly politically and economically? Definitely yes, but then again some other countries and entities deserve a second look and in relative terms the US debt wouldn’t look so bad.

An interesting “side” question: Has the S&P’s decision, however, tied Moodys and Fitch’s “hands” politically and made it much harder for either of them to downgrade the US debt? A big “yes”. S&P has shot its whole industry in the foot and pretty much guaranteed that US politicians will again review their status as NRSROs (nationally recognized statistical ratings organizations), so the last thing on Moody’s and Fitch’s mind is to provide more fuel for their own funeral pires.

What does that say about the sad state of governance in the world of Politics and Global Finance? A lot, unfortunately… By the way, the FT.com had a lengthy and great article on raters on July 24th.

Now for the hard part. What to do now?

First of all, remember the “fat pitch” metaphor: in the baseball analogy, investing is like being in the batter’s box in a game where there is no strike count. That is, you can wait for the “fat pitch” in your hitting sweet-spot – and when it comes, swing at it full-power and knock it out of the park.

(For baseball-challenged readers, think of a tennis match in which you get to choose which serves you want to return. When a serve comes in with the the right speed, spin and height you hit it hard for that great return winner.)

Warren Buffett waited years for this, and a clear signal that he is getting excited is that he has even entered a bidding war for an insurance company, competing with not one, but two existing offers. That’s the value of having US$ 47 billion in a severe market fall. If it continues, he will set up the “slingshot” for Berkshire’s future returns. As one should always keep in mind, there is both a defensive and an offensive side to holding a large cash position.

That is not at all a requirement to act right now, but it is such drastic and generalized price movements that can create selected opportunities in companies one could only dream of.

Second, beware the search for “safe havens”. You’ve read about it here in the last month, twice (here and here). It’s better to frame your investing career/ philosophy as if there is no safe harbor, because one day there won’t be.

Finally, stick to your game plan. Calm down. Think long-term and so on – yes, we are repeating ourselves and the words of so many before us, because it works. It’s definitely hard, it takes patience, discipline and perhaps – as Warren Buffett says – a special “wiring” of one’s brain in order to keep one’s head when people around us are losing theirs – ops, another old analogy.

And if you’ve read this far, this is what Buffett had to say regarding his “fat-pitch” approach in a 1974 Forbes interview (H/T to Todd Sullivan):

“I call investing the greatest business in the world,” he says, “because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

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