Buffett has clearly spotted that the bull market for T-bonds is over and is moving his money from a bull market into what he hopes is the bottom of a bear market for equities. In any case if the bond market suddenly tanks under the weight of the bank bailouts, Buffett will still be onto a winner with a timely shift to an asset class that will fall by a lesser amount.

Let me put that in more folksy Buffett language. You sell T-bonds - which foolish investors think is the safest asset class in the world - and buy equities. Buffett makes a fair point in his explanation saying that share prices may not be on the floor yet, and that he has no idea when a bottom might come.

The switch is a question of relative value. Bonds are going to crash, equities have just crashed. So in which class do you put your money? The downside in equities is much smaller than bonds, so you go where you will lose least.

Cash not safe

What about cash? Buffett says you lose over the long term holding cash because it pays hardly any return above inflation. He says it looks the safest asset class now but that is an illusion.

True - as the governments of the world flood the globe with money (as T-bonds or just money) then inflation will soar. This is back to the Weimar Republic days of Germany in the 1920s when in order to pay down the debts of the First World War (read $5 billion? banking bailout), the government was forced to print money.

In the end it took a wheel barrow of cash to buy a loaf of bread. Then Hitler took over, repudiated the debts, created the Reich Mark and started public works and rearmament that climaxed in World War Two and an almost successful attempt to take over the world.

Hopefully the political consequences of the bank bailout will be less disastrous this time. But the economic impact is an inevitable consequence of the trillions being injected into the monetary system.

Inflation certain

Like Warren Buffett not knowing when the stock market bottom will come we know that it must come. Timing the impact of global bank bailouts on cash and inflation is impossible but we know it will happen.

Buffett’s response is to flee bonds, ignore cash (which does not carry the capital downside of a fixed interest instrument like a bond) and go straight to equities. He will, of course, be highly selective in his buying - and go for companies whose business models make them long term survivors.

It helps, of course, that millions of Buffett watchers will now rush and buy all the stocks that he already owns (a safe assumption is that he will top up these stock holdings first). To that extent when an oracle speaks its words are self-fulfilling.

Gold and silver stocks

However, if you choose to sell treasuries - and this is the wise decision, not buying stocks which is something of a smokescreen - then consider gold and silver shares.

If Warren is right about inflation - and both gold and silver have a fixed supply so they just have to go up in value with inflation - then the currently bombed out shares in precious metals just have to be the best buy in the entire stock market. I expect his own precious metal shareholdings will be kept quiet as he will want to buy as much as possible before anybody catches on.

In the Weimar Republic share prices actually surged with, and even above inflation, while those holding debt saw their investment destroyed by inflation. So joining Warren Buffett in his probably premature shift into shares (although he gives us no information on how much or which stocks he is buying, of course) is not such a bad idea - but do not do it with leverage or you might be wiped out by another down leg.

Some analysts see a recovery in stock prices from now until after the presidential election, with a nice post-election rally, and then another leg down in prices - perhaps to 6-7,000 on the Dow - with a real bottom next spring.

Of course, you could be caught in a bond crash before then, and you should be looking to protect yourself from the dropping of this particular shoe - the biggest capital market in the world. And what will that do to bank capital ratios? They will have to go back to the governments for another bailout, and how will that be funded? None of this is good news, unless you hold precious metals.

Peter J. Cooper

http://arabianmoney.net/

-- Posted Sunday, 19 October 2008 | Digg This Article