original mungerville

I agree that Berkshire remains undervalued - more so relative to the market (as I believe current corporate profits margins are unsustainable). Its important to understand that Buffet bought a railroad worth at least 56 Billion for over a 40% discount! That's a lot of value-add for one deal! Soros made $1B shorting the Yen just recently, Buffet made $20 Billion on BNSF! With that kind of deal-making Berkshire still has some decent runway in front of it. Meanwhile Goldman warrants and Heinz deals will keep Warren out of the bars while he waits for the next big deal.

It has been my view that the Shiller backward 10-year P/E method of estimating the priciness of the market underestimates just how pricey it has become. If you listen to Shiller at the below link he is basically saying its at 23 times which is above average but not a super rich valuation. http://www.valueinvestingworld.com/2013/04/robert-shiller-on-wealthtrack.html However, Hussman's analysis (see link) also corroborated by GMO is compelling. Just eyeballing the second graph over the past decade ie 2003 - 2012, it looks like profits after tax have been at least, what? more than 33% higher than the long term average (ie long term average of 6% whereas the average over the past 10 years looks to be over 8%, so greater than 33%) http://www.hussmanfunds.com/wmc/wmc130408.htm So if we reduce the "E" on Shiller's 23 times P/E by the same 23/(6/8) or a Shiller P/E of 23*1.333 = 31 now. Shiller says that in 2000 it got to a P/E of 46 (which is higher than 31 now on this adjusted basis). What's funny is that in the interview, he says the valuations today are not "extremely high, ...its not like 1929, ...I hope, I hope not..." but of course the overvaluation in 2000 relative to GDP was way higher than in 1929. We are not quite in the 1929 vicinity but if corporate margins are indeed artificially inflated, then we might be in the top 5 priciest US markets over the past 100 years: 1. 2000 2. 2007 3. 1929 4. 1960s? 5. now? You can thank Q/E and unsustainable spending for recent returns.

I can't stand El-Erian, but I have time for listening to Gross.

Awesome notes. Thanks so much.

Ericopoly, I can't buy either but I wish I could! I am glad you and the board are doing well on those. With my day job, I have many conflicts of interest re global financials - which is really not good, it is a little ridiculous.

I think Jeast you may be right. Europe is Ok for now, lot of stimulus right now as well, bond yields still low now so the market can probably go higher. Any political blow-ups in Europe or bond yields rising or a US recession would reverse the rise in a hurry. Its definitely in the too hard to figure out pile. Although I have been hedged for a few years, even with the market at the current high, I am not feeling great about this being the time/year for the market to finally come down.

Well, everyone thinks we have the Bernank there ready to step in whenever the market goes down. Just like the second coming of Greenspan. This market can keep going higher...means I will lose even more money on my hedges. Watsa and I are getting screwed, I guess we might as well get screwed well.

Ericopoly, Sorry for butting in, but its 1) the dividend, 2) the rate it grows (ie the rate earnings grow assuming a constant P/E which equals the rate of stock price growth), but I would factor in 3) reversion to the mean over 7 years like Grantham (which is critical and means you need to know 3i) where we are now versus 3ii) the mean over time). So to keep it simple, those 4 data points. You always need the 4 main drivers: a current yield (whether dividends or earnings or sales with current profit margins), the future growth in the current yield, and where we are now relative to the mean we are likely to revert to over say 7 years. If you are holding for infinity, you probably can get away with only the first two! Or if stocks are crazy expensive like in 1999/2000, you can write an article in Fortune only focused on the first two in order to prove your point without needing to get into reversions to the mean (as Warren did).

You make a very good point on the important option value of cash for a buyer of stocks over the medium term.

bmichaud, Sounds like we are in agreement: once factoring in some reversion to the mean, basically we are at 0-1% real returns over 5-7 years. Of course the conundrum is that that could be a better return, in nominal terms, than cash or bonds. Cheers.

Bmichaud, How are you getting to the below conclusion in quotes. I can kind of see the 2.5% dividend (which is distributed as a percentage of record earnings of corporate America as a percentage of GDP, so I wouldn't count on that 100% going forward necessarily ...), but where is this 5-6% coming from? If real GDP grows at 2% which I think is a stretch, and if you assume 2% inflation, that's 4% total. There is no way buybacks would add another 2 percent? Even assuming no dividend cuts going forward, I can't get past 6.5% max for nominal and 4.5% max for real returns. Then, given you probably aren't going to hold the stock for 1000 years, and let's assume your hold period is 7 years, you need to factor in reversion to the mean in terms of corporate earnings relative to GDP, or corporate profit margins (take your pick) contracting to more normal levels. If they do that over 7 years (which is what Grantham factors in and which is likely over that period based on his back-testing) you are probably closer to something below 1% real return over 7 years from these levels...maybe a zero to negative real return could be expected. IF the money printing continues, which seems likely, the returns would be OK but they will be all inflation and not material real returns from these levels over 7 years. That's what I get from looking at Buffet's 1999/2000 Fortune articles and combining with Jeremy Grantham's analysis method. Deductive reasoning (and not inductive reasoning which you are using) is required to forecast expected long-run equity returns over a 7-10 year period because the boundary conditions become very important over say 7 years (relative to a 100 to 1000 year holding period). For example, if stocks are double fair value at time 0, over 7 years, you can expect them to drop by 50% over 7 years or say something like an 8% compounded loss every year for 7 years. That 8% has to be deducted from the 7.5 to 8.5 prediction arrived at through using only an inductive approach. (Grantham's approach incorporates this effect and he backtests 7 years as a good timeframe for reversions to take place across various asset classes including stocks - down from his previous 10 years reversion period using in the early 2000s.) If we are talking about stocks at double fair value at time 0 but are holding until infinity, there is no reversion to the mean which needs to be built in (so the inductive approach you are using becomes more accurate) but your returns are still going to be lower because your initial yield is lower than it otherwise would have been (Buffet's simple approach used to make his point in Fortune 12 years ago uses mainly inductive reasoning; it was simple to get his main point across that equities were really overvalued but he knew it wasn't the full detailed answer). "So purchasing the market here one could expect to earn 7.5% to 8.5%. 2.5% as income from the dividend and another 5% to 6% as capital gain from the growth in the dividend."

This I don’t believe is correct. Also Markel is an insurance company, with a stock portfolio which is grater as a percentage of equity than Fairfax’s, and yet they never hedge. What makes sense from a business perspective is to be cautious and conservative when the sea is flat, and to grow by leaps and bounds when the storm brings outstanding opportunities. Investing is the same. That is what Mr. Mellon did, that is what Mr. Buffett did (when a great opportunity came his way he always had the cash available to take advantage of it, always!), and that is also what Mr. Watsa is doing right now. Of course, trading might be different. And maybe a lot of trading opportunities are available now, special situations, arbitrage, deep value cigar butt stocks with a catalyst for the last puff, etc. giofranchi “As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes I agree completely with giofranchi. Fairfax is hedging because they see risk in this environment (but they want to exploit their value investing edge to the full extent at the same time) not because they are an insurance company. I believe they would put up to 100% of their book value into stocks unhedged if valuations were reasonable. (This is about the ONLY think I disagree with Sanjeev on!).

Uccmal, Thanks, always nice to hear from you. I am still using IWM put options as a hedge. I will be doing much more bottom-up research shortly (and thus will again start to post more) as I transition a greater part of my time/efforts into the investing field (and away from my day job) later this year. I am glad to see many board members took advantage of, and made out well on, their BAC options - sounds like you did quite well on those as well. Congratulations.

I've been fully invested yet also fully hedged for 2 to 3 years now - a very expensive position (although in 2008 my portfolio was up 70% rather than being down 40%) - but I have done so to avoid making a macro bet as I view being long only as taking a macro bet. Everything economically has held together thus far - it seems with the Euro holding together now and the US and Japan printing money, I tend agree with Uccmal that we could still have a big move up this year as well (its funny that even at this point, despite the big run-up in stocks over the past few years, I am actually still quite concerned about my hedged position rather than being sure the market will decline this year due to its very high valuation). Relative to GDP, which is a more conservative measure than using Case-Shiller PE10, the market's high valuation is in the top 4 of the past 110 years - the other highest valuations being: 2000/01, 2007, and 1929. Countering this, bonds seem unattractive as does cash. There is no way, in my view, that interest rates will rise until the market forces them up. So I am expecting a disorderly adjustment to the macro imbalances at some point in the future - but who knows when. I still hold a very large out-of-the-money long position in silver, I like Berkshire relative to the market and think that position could be leveraged to a multiple of the portfolio when it was closer to the buyback floor price. But nothing too exciting right now in terms of great opportunities. (I have liquidated my call options on RIMM and OSTK recently; I was precluded from buying BAC options but had I not been, I would have invested heavily there alongside of other board members. Its amazing the opportunities the market provides just looking at RIMM, OSTK and BAC.)

I too am applying the same strategy - I use options for asymmetry but they are costly and can lead to even bigger lumps over time!

Tepper's point is valid that it may be a bit stupid to ignore the stimulus of $1 trillion in asset purchases in 2013, and another trillion in 2014 and another in 2015 - especially given similar policies in the EU and apparently Japan now. Also, he is saying relative to government bonds, stocks aren't that bad. I would add, high-quality stocks relative to stocks aren't that bad either. So stocks are high, but the new safe haven may be high-quality stocks rather than gov't bonds (eg, in Spain the company which owns Zaras is viewed as a safe-haven investment, as much as or more so than government bonds - this could also happen with high-quality US stocks.)

I agree with your concept completely giofranchi - following the Fed will feel good until it doesn't. The only adjustment I would make is that we are currently much closer to the 1929 peak in terms of valuations then that graph suggests. In the past century or more the following were the major peaks for the US stock market: 1. year 2000 by far the highest valuations 2. 1929 3. 2007 4. Right now 5. Sometime in the 1960s (I think) In the last 12 years, we have had 3 of the top 5 highest valuations in US stock market history - due mainly to Fed policies. I think the Shiller 10-year P/E underestimates the severity of the over-valuation present in today's market. A better approach might be to compare the US stock market to GDP (as Buffett did in Fortune in both 1999 and 2000, and as Watsa did as well in this decade, along with Grantham) which demonstrates the more important level of over-valuation. Having said all that, Tepper may be tactically correct for 2013. In the long-term, these levels of valuation are definitely not attractive. We could easily see US stocks at the same levels (or lower) in real terms 5 years from now.

Look like Hussman also thinks the US entered recession in Q3...see below (BTW, ECRI claims that in 2011 or whatever they said the recession would start at the latest by mid-2012 and so are claiming they may still be right. I don't know all the history, and I am not expert in these economic details, I am just raising the flag that the US may already be in a recession as ECRI is reasonably credible - whether they were 6 months off, or only right on the very outside of their call, I don't really care too much. They may indeed still be proved wrong.) December 3, 2012 How to Build a Time Machine John P. Hussman, Ph.D. All rights reserved and actively enforced. Reprint Policy With industrial production, capacity utilization, real disposable income, real personal consumption, real sales retail and food service sales, and real manufacturing and trade sales uniformly declining in their latest reports, coincident economic indicators – having generally peaked in July – are now following through on the weakness that we’ve persistently observed in leading economic measures. We continue to believe that the U.S. economy joined a global economic downturn during the third quarter of this year. While we use a broad range of signal extraction and noise-reduction methods in our own work, the economic data in recent months has required less and less sophisticated analysis, as many of the most reliable leading economic measures have turned clearly lower (e.g. Philly Fed Index, Chicago Fed National Activity Index, and the new orders and order backlog components of numerous regional and national Federal Reserve and purchasing managers surveys). Still, the leading/coincident/lagging relationships across these indicators remain important. Not surprisingly, analysts have now turned to the last refuge of the economic data, which is to focus on historically lagging measures such as payroll employment. ....

I agree with him. I see a Kaboom ahead as well... but timing is of course he issue. My idea is to wait it out while not going broke: I am shooting for 10% annual returns instead of my regular 20% (just managing my own money), and staying hedged (while buying the odd call option; eg OSTK and RIMM at their lows, BRK-B stock at near book, etc - simple stuff). Trying to find cheap hedges with convexity if I can find them. Maybe a good pairing (deflation / inflation respectively) that fits this description would be: - very long term put options on JGBs with - very long term calls on silver One thing for sure though, don't stop value investing for the long-term. Whether or not those value positions should be fully hedged with stock market hedges, or partially, and/or coupled with a convexity pairing as above is something to consider based on personal preference, etc. I tend to hedge a lot and take a lot of pain for years 'till I get my 50-100% gain from the hedges. Its very hard to do. I certain don't like this environment and agree with Gundlach that long-term the pressure just keeps building. I am not clear, however, whether its pressure or whether it should be described as the lever the authorities will eventually use just keeps getting longer and longer due to stimulus such that, even assuming they do try to withdraw stimulus at some point (big assumption) they have no real way of doing it in a controlled manner - ie the system has become so dependent and fragile while at the same time their lever so long . I think in that process, we have the Kaboom moment.

I don't know, he hasn't been proven wrong yet: he said it would start early 2012 or if not by mid-2012. He then said we would only know 6-mths later. So he's got one month to go before we can say he was wrong on the original call. He seems to have been consistent in his message throughout. The New Year will show whether he was wrong or not. We certainly don't have the stock market as a forward indicator this time given all the QE. Further, its not like the long-end of the bond market can really invert either! Normally, the latter is a good recession indicator...but its QE to infinity it seems. This doesn't end well.

Good. Get the bastards.

Hey guys, I guess I haven't been posting much last few years... but in any case, I hope they get that SOB at SAC.

I hope they get the bastards.

Of course it is. Bill Gross, Watsa, Ray Dalio and many other greats think the same thing.

For what its worth, I'm still pretty much 100% hedged - have been for about the same period that Watsa has. Been leveraged and hedged in one way or another for probably 60-70% of the time since 1999. Can't wait to get this bubble over with so I can stop hedging!