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Thursday, May 20, 2010

2010 Berkshire Meeting

Going to Omaha and Pasadena every May had become a fixture in my life for the past few years.  I decided to break with this little tradition starting this year.  Initial thoughts were driven by the difficulty of managing two mostly personal trips to the other side of the world in a gap of one month (the second for other unavoidable reasons).  Then, came the news that Berkshire was splitting the B shares and the final nail in the coffin was that the canceled international shareholders meet and greet.  The last one is where people from outside North America got to meet the man himself.  Besides, over the years the quality of the crowd has been deteriorating, that is, in their seriousness towards Berkshire business.  Now, it has ceased to be less of a convention and more of a vacation spot.

My decision cannot be equated with a full blown-out divorce, it is more like a couple deciding that they need to spend time apart.  And, the big significant difference is this relationship is one sided commitment from my side.

Twitter and live coverage by Omaha World Herald and Morningstar made up for the physical distance.  Other bloggers have done an excellent job of note taking and posting them.  I am posting some links at the end here.

First some excerpts from the annual report for 2009 and the letter to shareholders:-
Following a question in 2009 meeting, he added an explanation to the Principle 9 of the Owner's Manual.  (For the uninitiated, Berkshire codified its Owner-related principles in 1996 and it addresses the agency problems inherent in a corporate form of organisation where the manager's interests and the owner-shareholder's interests are not aligned.  It is a must read for any management/finance professional).

"We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.
I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.
When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.
The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense."

Earlier it said:
"We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds."  And, the question last year was, since you failed this test, will you pay a dividend?

From this year's meeting - "Buffett is asked about whether Berskshire would issue a dividend. Buffett says every dollar left in the business has produced something over a $1.30. Buffett says Berkshire has met the test of finding profitability. Berkshire has made every $1 of retained earnings make more than $1. Buffett says if the company does that over time, it will continue to retain earnings. "

Investment Strategy

"In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations are met – and we believe that they will be – Berkshire’s ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead."

when premiums are wrong, go play golf. (too many ppl confuse action w progress/value)
Buffett: events around world of last few years makes me more bearish on all currencies than before
We have always had the same potential, it's our perception of what is possible that changes.
Buffett: lending money (buying bonds) boils down to "are they going to broke or not", equity q is much more complicated
Buffett: I knew enough to lend them money, but didn't have enough info to buy the equity [in Harley]
LOL! Buffett: I kinda like a business where guys tattoo your name on their chest [re: Harley]
"If you wanted to bet on higher or lower inflation, you'd want to vote on higher. Maybe a lot higher."
Buffett: your money can be inflated away, but your talent can't be inflated away--regardless of the currency
Buffett: if inflation gets going, it will be hard to stop; trend is not destiny, we have power to control our future
"Talent is the perfect asset to deal with any monetary condition (inflation/deflation). Charlie and I will have to rely on money."

When it comes to managing money, Charlie Munger just said: "Take the high road. It's far less crowded."
"I think we're in for a long period for where the ordinary result is not going to be very exciting." -- Munger.
Charlie: equities are the best of a bad lot of available opportunities. In for a long period where ordinary result not exciting
Charlie: fundamental theory is pragmatism because it suits our natures and because it seems to work better
"It's not about how big your circle of competence is but rather on knowing where the perimeter is" -Buffett
Buffett says the pressure of extraordinarily low interest rates on asset prices is hard to overestimate
Buffet on 0.10% interest rates: If you invested at 0.10% when Columbus would have almost doubled your money by now!
Speculators do no harm if they are bubbles on a steady stream of enterprise - WB quoting Keynes
...but it will be ill-done if enterprise becomes a bubble on a whirlpool of speculation - Buffett quoting Keynes
Munger says stats on gov't debt are misleading because only includes bonds outstanding and not unfunded obligations
"if you want to give away all of your money to charity, it's a great tax dodge." - Warren Buffet
Munger: If BRK would create make-work jobs to increase human hope, the effect over time would be to reduce human hope
"If you believe in creative we do in this better also have a social safety net" -Buffett
Munger: The politicians are not behaving better now that the newspapers are weakening. We're going to miss the newspapers.
Munger: It can be hard in India because of gov't regulations. This could lead to faster growth in other emerging markets like China

On buying a rail road:-

"Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant.
We see a “social compact” existing between the public and our railroad business, just as is the case with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to the compact should – and we believe will – understand the benefit of behaving in a way that encourages good behavior by the other. It is inconceivable that our country will realize anything close to its full economic potential without its possessing first-class electricity and railroad systems. We will do our part to see that they exist.
In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital."
Managing and Evaluating Managerial Performance

Buffett clarifies Berkshire's measurement metrics for evaluating managerial performance.  "From the start, Charlie and I have believed in having a rational and unbending standard for measuring what we have – or have not – accomplished. That keeps us from the temptation of seeing where the arrow of performance lands and then painting the bull’s eye around it."
Then he guides you through the maze of seemingly complex thought process to arrive at a simple solution that is typical of Buffett.  S&P 500 is the benchmark; Berkshire's share price can be influenced by market forces that are beyond the control of the management; intrinsic value of Berkshire is hard to calculate; so we use book value though it understates.  Then he goes to show you what if they had calculated performance using market value.  And the conclusion, "..our defense has been better than our offense, and that’s likely to continue." and that "our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue." and promises better-than-average results due to the outstanding businesses and truly great managers.

Reiterating the managerial excellence is a little movie that is played with music to "My Favorite Things" from The Sound of Music.  And comments like "If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit." (talking about Ajit Jain of National Indemnity)

From the meeting (courtesy Omaha World Herald's Joe Ruff)- "Buffett is asked about compensation of its managers. Buffett says Berkshire never uses a compensation consultation. Buffett says it is hard to determine one standard for Berkshire's diverse companies. Buffett says some businesses are easier to manage than others, some use more capital expenses than others. Buffett says he tries to figure out how best to pay people based on the economic characteristics of their industries. Buffett says it does not take that much time and it is not rocket science. But he says it does take some understanding of the characteristics of the different companies. And he says it requires some interaction with the managers, with them and Buffett sharing ideas about what they really are contributing to the company. Buffett says Berkshire pays some big money, with manager making 10s of millions annually. And we have managers if we suffer they suffer. But Buffett says everyone wants to be treated fairly. Buffett says the important thing is to have the salaries reached understood by the managers. Buffett says managers really need to widen their moats compared with other companies in their industries. Munger says it is amazing how simple it has been, how little time it has taken and how well it has worked."

"Buffett is asked about having managers who misbehave ethically or legally. Would Berkshire intervene then? Buffett says yes, sure. Buffett says he wants to hear about problems. Buffett says there is an internal function in Berkshire that anything that comes in relating to alleged bad behavior it will be investigated by Berkshire. Everyone once in awhile there have been important transgressions that have come to me. We encourage that. Buffett says a letter goes out every two years, a page and half long. Buffett says in the letter it talks about having more money than it needs, but reputation is important. Buffett says a new line says if reason you are doing something because the next guy is doing it, that is not good enough. Buffett says there has to be a reason better than that. Buffett says Berkshire will have more trouble than it has in the past because it is so much bigger than it used to be. But Buffett says he and Munger want to hear about it fast if there is trouble."

Buffett on compensation: It's not rocket science but requires an interaction w/ managers: what do they actually add 2 the company?
Buffett: what I pay managers for is to widen the moat
Buffett on compensation: You still have to treat people fair, even if they don't need the money.

"Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless."
"When something is found or alleged: Get it right, get it fast, get it out, get it over. But get it right is number one".WB

There are many CEOs in america I would like to see gone and Loyd Blankfein is not one of them, says Charlie
All I want to know is where I’m going to die, so I’ll never go there

I would love to see another annual report with the following appropriate counsel on avoiding trouble - "Long ago, Charlie laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll never go there.” That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled “Invert, always invert” as an aid to solving difficult problems. (I can report as well that this inversion approach works on a less lofty level: Sing a country song in reverse, and you will quickly recover your car, house and wife.)"

What won't Berkshire do?
- avoid businesses whose future they cannot evaluate;
- never be dependent on the kindness of strangers;
- subsidiaries operate on their own - "would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy."...."Charlie and I will limit ourselves to allocating capital, controlling enterprise risk, choosing managers and setting their compensation."
- make no attempt to woo Wall Street. "want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur."

""Success is avoiding stupidity" Charlie Munger ;) "
"You give human beings the flexibility to do absolutely anything they damn well please, they will go plum crazy" - CM
"You want to create a structure that minimizes the weaknesses of human behavior" -Buffett

Taking responsibility:

"Last year your chairman closed the book on a very expensive business fiasco entirely of his own making." and goes on to talk about the credit cards to GEICO customers (I was one of them, who closed the card when they decided to charge the fees.)
"GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.
I was just older."

"The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged."
"NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million.  It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.  Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming"
"Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractionalownership industry, insisted upon. Dave and I have the strongest possible personal interest in maintaining these standards because we and our families use NetJets for almost all of our flying, as do many of our directors and managers. None of us are assigned special planes nor crews. We receive exactly the same treatment as any other owner, meaning we pay the same prices as everyone else does when we are using our personal contracts. In short, we eat our own cooking. In the aviation business, no other testimonial means more."

"It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer."

"In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.  It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.  The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well."

On derivative contracts:-

- Though it’s no sure thing, I expect our contracts in aggregate to deliver us a profit over their lifetime.
- Only a handful of our contracts require us to post collateral under any circumstances.
- you should expect large swings in the carrying value of these contracts. "..these wild swings neither cheer nor bother Charlie and me"
"To date we have significantly profited from the float they provide. We expect also to earn
further investment income over the life of our contracts."
"The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it. 
"Buffett is asked what useful function do derivatives serve? The questioner says we have done well without them for years. Buffett turns the question to Munger. Munger says derivatives on things like grain or other commodities are fine, but if all other derivatives vanished he would be fine with that. Buffett quotes John Maynard Keynes as saying speculators do no harm if they are bubbles on a steady stream of enterprise. But it will be ill-done if enterprise becomes a bubble on a whirlpool of speculation. Munger says if a small group with a lot of money and influence are very interested in something, they will win out. He says that is just the way it is."

Warren: different prices for collateralized vs uncollateralized derivative contracts akin to renting furnished or unfurnished apt.
Munger: If all derivatives vanished, the world would be a better place
Issuing Shares for shares
"Our subsidiaries made a few small “bolt-on” acquisitions last year for cash, but our blockbuster deal with BNSF required us to issue about 95,000 Berkshire shares that amounted to 6.1% of those previously outstanding. Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy. 
The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the current market price, why in the world should we “sell” a significant part of the company at that same inadequate price by issuing our stock in a merger?
In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver them the intrinsic value of their own shares – the ones they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders.
Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 11⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.
If an acquirer’s stock is overvalued, it’s a different story: Using it as a currency works to the acquirer’s advantage. That’s why bubbles in various areas of the stock market have invariably led to serial issuances of stock by sly promoters. Going by the market value of their stock, they can afford to overpay because they are, in effect, using counterfeit money. Periodically, many air-for-assets acquisitions have taken place, the late 1960s having been a particularly obscene period for such chicanery. Indeed, certain large companies were built in this way. (No one involved, of course, ever publicly acknowledges the reality of what is going on, though there is plenty of private snickering.) 
In our BNSF acquisition, the selling shareholders quite properly evaluated our offer at $100 per share.  The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie and I believed to be worth more than their market value. Fortunately, we had long owned a substantial amount of BNSF stock that we purchased in the market for cash. All told, therefore, only about 30% of our cost overall was paid with Berkshire shares.
In the end, Charlie and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.

I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion.
When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t ask the barber whether you need a haircut.”

"our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”

Media over-exposure
Tweet : "buffett is appearing in Wall Street 2 w/ michael Douglas? Who knew?"
From the meeting "Buffett is asked if his increased media exposure is good for Berkshire shareholders. Buffett says probably not. Buffett says he has seen over the years the development of broadcast television over print. He says if you want a record of what you actually said, instead of a reporter's and editors' interpretations, it is great to have the broadcast version. I like the idea, whether it is charlie rose or CNBC, a record of my own words, instead of someone's interpretation of it."

Charlie: Every business should decline a lot of business that it doesn't. Just because it's legal, doesn't make it right
"The ideal is that we celebrate wealth only when it has been fairly won and wisely used." -Charlie Munger
Charlie: we get offered things that people won't sell to anyone else. We have our own ethics-based screening device
WB if reason you are doing something because the next guy is doing it, that is not good enough

"The old men (Warren & Charlie) always continue to learn which is essential!" -Charlie Munger
If you keep asking questions at a young age like that, gradually you learn. Love when Munger ruminates on his childhood.
Charlie: if you're scared to do something, maybe you should get your feet wet with a little more failure.
Charlie: go to bed each night a little wiser than you were when you got up. People who do that almost never utterly fail

Buffett says in a country where the undisciplined are unpunished it brings people to wonder why they should behave properly
"When you picked your wife, you picked the best who would take you. We should live the rest of our lives like that." Charlie Munger

I am a twit @seshnath 

Links to Notes:-

Wednesday, May 19, 2010

Gazing into the Crystal Ball

Now that everyone is talking of an economic recovery, here is a thought experiment on how the future might look like.  Let us look at some indications:-
1. Ballooning of central bank balance sheets;
2. Price fixers have decided that cash is cheap (Read, Central Banks are keeping the interest rates low);
3. Governments have found themselves overstretched on their budget - be it municipalities or the PIGS (no, I am not calling the Europeans swines - look it up)of Europe.

There are two paths that seem likely out of this situation.  One seems to be what everyone is fearing - inflation.  And it seems to be the easiest way out of the situation.  Looking at the lack of political will and the bickering, it seems to be the likely course of action to most people around.  The interpretations seem to be muddied by further assuming that tail is wagging the dog and mixing correlations.

Let us diverge a bit;
Think of Gold-Oil ratio - Oil is fast consumed, people can't wait to dig enough out to finish it.  Gold mining adds about 1% to the overall gold stock each year and it is a metal that is hard to be destroyed.  Most Gold demand is from the craze for the glitter and an automatic response to go back to the good ol' days.  Jewelery demand is lower compared to the investment demand.  (Even people who buy jewelery in India think of it as an investment, more so these days).  Part of it is the belief that the central banks will have to return to gold and the other part is that gold is a hedge against inflation.  Now, in investments, unexamined beliefs are a road to disaster.  Believing that the central banks world over are going to gold backed currencies is to believe that people will stop using automobiles and start to use horse buggies or bullock carts, just because they pollute.  The more likely course of action is that everyone will learn to live with fiat currencies just like we learned to live with higher emissions.  And expect an outcry against pollution, every time there is a smog.  (Note to Gold Bugs, Romans also used salt (the word salary comes from it)as currency, should I start buying up Salt as well?)

Coming back to Oil, it is scarce in supply and expected to get scarce by most accounts.  Varying accounts put the peak oil production in different years of the first half of the last decade.  The solutions to this are complicated - yes, there is wind, solar etc etc.  Think of various uses of petroleum products; it is in food, water, air (conditioned or polluted, that is) and all the infrastructure that we have now is built on it as the primary source of energy - think of the engineering problems of running an airplane on coal or for that matter, a car using hydrogen.  When the change away from oil happens, it is going to be disruptive - systemically and financially.  Being someone who doesn't like to bet, I would neither try to invest on that thesis; nor do I have the necessary expertise to do so.  I would keep my eyes open though.

Getting back to our thought experiment, and path number one, which is inflation.  Inflation is essentially an invisible robbery of the saver, the creditor and the pensioner.  When you have so much of future obligations, without matching income in sight; it is a tempting situation to inflate, especially if you are the debtor and have pension obligations. But once you go down that path, it is difficult to regain the credibility for another generation or more.  Think Germany in the 20s. 

What will happen if inflation rears its head - the central banks have to raise interest rates, impact will be a lot of unwinding of the carry trade (short/borrow dollar, long/buy you name it).  Asset classes other than dollar will get a mark down.  And, because of the higher opportunity costs they will stay marked down for sometime, until the expectations change.

Independence of Central Banks also are called into question these days.  This time around, will there be enough political will/backing to go through this pain since it implies lower asset values?  The proportion of voters depending on asset values is higher than before since current yields are paltry everywhere. 

Second path is deflation of balance sheets, the central banks somehow get a backbone to stand up to their political masters, get the prudence to deflate and keep deflating their oversized balance sheets.  It will mean money will be sucked out of the system.  Less credit, means longer term projects with returns much later in their life cycle will be the first to get knocked out.  Think infrastructure projects which have a long gestation period or projects which are end-loaded - where the majority of cash flows is at later stages.

Let us assume, that demand doesn't pick up in Euro land and Uncle Sam's households and it starts to look like low level of aggregate demand for a longer duration, it will also imply the creation of a long-term bubble elsewhere in the world where demand has picked up.  Essentially, automatic savings like 401ks and pensions will flow like water from higher-priced (low-yielding) assets to lower-priced assets and this will distort riskiness of those assets again.  It will imply deja vu all over again.  Think of other secondary impacts, foreign ownership of assets in regions where savings levels are high.  It will start to look like colonialism in a new form.

Personally, I prefer the second path to the first, since deflation means lower prices and better value for the money.  Inflation is an all right situation as long as you keep reinvesting in yourself and keep updating your skill sets.  It is an ugly scenario for a saver or a pensioner, especially given the trend in economic measurement under estimating inflation.  Either way, stocks as an asset class are going to suffer.  Does that mean I am going to not invest?  Hell no!! Just that I will be very cautious until I see clear trend.  Until then watch out for the PE re-rating in your stock returns.

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