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Warren Buffett on Fed Policy

End of Policy is Worrisome

Written by Briton Ryle
Posted March 7, 2013

 They say a rising tide raises all ships. But tides do change. How many ships will find themselves dragged out to sea then?

It’s enough to get Warren Buffett a little worried.

For years now, a rising tide of cash has been rolling onto the shores of the American economy. Where is it coming from? From the Federal Reserve—at a rate of some $85 billion a month almost evenly split between the purchasing of mortgages and repurchasing of Treasuries. The government has been buying back its bonds.

Heavy bond buying raises price and lowers yield. Institutional and private investors do not get overly enthusiastic about bonds when the Fed is crowding the market. Would you attend an auction with Mr. Government Trillionaire sitting in the front row?

Instead, investors are going to stocks, as they have been since the Fed’s stimulus program started some 4 or 5 years ago. As a result, the broader indices have been riding this rising tide of investment into stocks all the way to multiyear highs, and recently to a new Dow Jones all-time high of 14,286.37 struck this March 5th. And it keeps going up.

While this relentless march to higher levels across almost all sectors has some investors popping Champaign corks, it has Warren Buffett and other instightfuls worried, as Buffett explained on a CNBC interview as transcripted by CNNMoney:

“’All over the world everybody that manages money is waiting to catch the signal that the Fed is going to reverse course,’ he said. ‘I think they're on a hair trigger. There are an awful lot of people who want to get out of a lot of assets if the Fed is going to tighten. Who knows how it will play out.’”

Indeed, the sense of nervousness in the investment world is real. We all caught a glimpse of this jitteriness when stocks fell some 1.5% on February 25th “after the Fed's minutes suggested some members supported slowing asset purchases from their current pace,” as CNNMoney recounts. “[Buffett] said that was just a small preview of what could be extreme market reaction once the Fed actually does start selling the trillions in Treasuries and mortgages it now holds.”

This is not to say that the Fed has not given thought to this. You can bet the bankers on the Reserve’s board have planned their exit probably even more than they planned their entry.

“I think [Ben Bernanke] has been absolutely terrific as Fed chairman, and I'm sure he's thought a lot about how he unwinds this,” Buffett expressed his confidence to CNBC. It’s the investors’ reaction that has Warren worried. “I don't think it's totally predictable what will happen when it does happen.”

But keep in mind… when it does happen, it won’t be just the ending of new money being pumped in by the Fed; it will be the beginning of a long-term removal of money from the system.

The government will stop buying bonds and start selling them. Bond prices will begin to fall, yields will begin to rise, and investment dollars will run like water downhill—out of high stocks and into low bonds. When the tide of Fed money starts flowing in the other direction, ships will fall, and many will be washed out to sea.

Knowing, then, that at some point interest rates will begin to rise and stocks will once again ride the volatile choppy waves of a sea in transition, should investors avoid the stock market all together?

Well, perhaps that is going to the extreme, as Warren wrote in his latest annual letter to shareholders on March 1st. “American business will do fine over time. And stocks will do well just as certainly,” he wrote. “Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it,” cited the San Francisco Chronicle.

Buffett elaborated on this point during his CNBC interview, saying that stocks may not currently be “’as cheap as they were four years ago’ but ‘you get more for your money’ compared to other investments. He added, ‘The dumbest investment, in my view, is a long-term government bond,’” quotes CNBC.com.

The key is to think as the greatest stock investor of all-time does. As I mentioned in a previous Wealth Daily article on Warren Buffett’s investment style, he is not a short-term stock trader but rather a long-term stock investor. “We're buying stocks now,” he revealed in his interview. “But not because we expect them to go up. We're buying them because we think we're getting good value for them.”

What is good value? Perhaps a one-line snap-shot of Buffett’s beginnings can answer that. I thought this one opening line of the San Francisco Chronicle’s article encapsulates it all… “Warren Buffett … built Berkshire Hathaway Inc. into a $250 billion company with funds from insurance units.”

That’s it, isn’t it? Cash. He built his megalithic stock portfolio from the cash that his insurance holdings brought in.

And cash is what will help any company stay afloat when the tide of government money starts flowing the other way. A company that can generate cash through all market cycles will survive and fare better than those that are awash with debt.

Remember, interest rates are the lowest they will ever be right now. Sure, in a rising market, companies heavily laden with debt can be hard to distinguish from those with less burdensome debt because they are all rising together.

But start raising interest rates and let the tide go out—then take a look at what remains. Those companies that can steadily generate more cash than their debts are soaking up are the companies that will remain aloft, and they are the companies to be investing in now.

When the flow of money reverses course in the next major cycle—and even during those temporary short-term corrections that commonly follow fresh new peaks—cash will be the anchor that holds your ships in place, preventing them from being washed out to sea together with your portfolio.

Joseph Cafariello

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