Thursday, August 9, 2007

And Now What Wall Street?

I love water stocks, but only in the context of extreme anxiety about the overall stock market.

I've rarely been this concerned about the overall stock market. [Eric's Note: I delivered this speech three days after the Dow registered its all-time high]. It just doesn't feel right that we should be making new all-time highs when we have a myriad of issues that could undermine – and should undermine – valuations, or at least confidences in those valuations. It doesn't feel right when you have a housing slump that triggers a mortgage-lending debacle that triggers a credit-derivative crisis of unknown proportions.

Now obviously, there are some companies that are performing well. But in the context of these macro economic concerns, the lofty American stock market – and also the global stock markets – concern me. These record highs may be enjoyable, but they don't feel quite right. They feel uncomfortable...and it feels uncomfortable to enjoy them.

In a weird way, the stock market's all-time highs remind me of a recent incident. I was at a party with some friends of mine, and the girlfriend of one of my best friends sauntered over towards me. Then she came up behind me and started to massage my shoulders...and my neck...and my hair.

Now, I knew her a little bit. So on that level, the massage seemed almost okay. But on the other hand, I've known my friend for much longer...and he's a good friend. I've known him for almost 25 years. So I did what any trusted friend would do in that situation: I motioned to the girl to come down next to me so I could talk to her subtly. I whispered in her ear, "You know, that's really nice. But I want you to stop about ten minutes."

We're all tempted to do the exact same thing with our investment capital in the stock market. We are tempted, when things are seductively nice, to hang around longer than prudence would dictate. We all know that a morally ambiguous massage should not continue for 10 minutes. In fact, it should not continue for longer than nine the most.

Every second that you remain over invested in a risky stock market you are putting your capital at risk. Maybe the stock market is not so dangerous right now. Maybe it's not so bad. Many companies are performing well. But it scares me that the massive credit derivatives market has taken on a life of its own.

The credit derivatives market globally has increased form something like $1 trillion dollars in notional values five years ago, to something like $34 trillion currently. So you've taken a market that barely existed to something that is more than three times US GDP.

That's not necessarily a bad thing. In fact, credit derivatives are a good thing, as long as nothing goes wrong. They're a good thing, as long as asset prices continue to rise and as long as there are no serious issues that put optimism in retreat. The nice thing about derivatives is that they provide lots of liquidity. They make a lot of things work really nicely. They make share prices go up; they make hedge fund managers rich; and that provides a trickle-down effect throughout all of Greenwich, Connecticut.

Credit derivatives, therefore, provide livelihoods for innumerable support industries. Without derivatives, the plastic surgeons of Greenwich, Connecticut would not eat as well...and neither would the yoga instructors or the life coaches. None of these people would have the same lifestyles that they have today if it were not for derivatives.

But no one knows how worthless a collateralized debt obligation (CDO) might become in the event of a crisis, which may or may not be now unfolding. No one really knows what these things are worth in relation to their implied financial values, much less what they are worth in relation to a barrel of oil or a glass of water or an ounce of gold. This is not a purely theoretical exercise. What I'm talking about, really, is an excess of paper in the world relative to a finite supply of "stuff."

This connection between paper assets and stuff is the essential background of all resource investing. And this
background is particularly germane today, now that the US dollar has been falling. If you look at the resource markets in terms of the Canadian dollar, for example, you could argue that those markets topped out a year ago. Oil is not higher now in Canadian dollars than it was one year ago, and many resources are not. But in USD terms, most resources ARE higher than they were one year ago.

So are we looking at a bull market that springs from a traditional supply-demand imbalance? Or a different kind of supply-demand imbalance? Are we looking at a scenario in which there is not enough "stuff," relative to this avalanche of paper – not just dollars, but credit derivatives as well, and all manner of leveraged, paper assets?

So why do we like the water industry? In a word: Scarcity.

We like things that are scarce; they make for good investing. Paper assets have become too popular. I want the other side of that trade: I want to get rid of my paper, and to exchange it for the stuff that powers and feeds the world...and in particular, for the stuff that quenches the world's thirst every day.

This reminds me of a story: When I was 18 years old, I went backpacking in the High Sierra. It was a two week trip. You carried everything in – no re-supply. So we carried in all our food and all our fuel. It was my first-ever backpacking trip, and I didn't know that a backpack could weigh 85 pounds. It was extremely heavy at the beginning, especially with no prior experience. But as the days wore on, you got acclimated to it...and also the pack became lighter by virtue of using up what you had carried.

But the funny thing was, after 4 or 5 days of eating nothing by dehydrated food, we started to value REAL food a lot. Particularly the few pieces of vanilla caramels we had carried in. I don't remember which one of us brought these particular candies along on the trip, but several of us brought in different kinds of candy at the beginning. On the second night, we dumped all our candies on a towel and divvied it up. We went around the circle picking what we wanted. I picked all of those caramels and nothing else. Then, I didn't eat them for seven...eight...nine days. I didn't eat them. Everybody else ate theirs. By the ninth or tenth day, there was only one topic of conversation.

So I was able on the ninth or tenth day to trade those little things for five dollars or ten dollars, because a dollar bill had no value, literally, in that environment. It was uncanny! I was also able to trade caramels for services. I was able to trade them for crrying things, for example. We had tents. Tents added five to six pounds to your pack. So I'd say, "If you want a couple of these little caramels, you're going to carry that tent of mine."

At the end of the two-week trip, I walked out of the wilderness with $56 – those were 1978 dollars, I might add – worth about twice today's dollars. So quite literally, I was able to trade a kind of "essential resource" in that environment for capital and energy. I think the world that we live in will reward investments of that sort. You want to be buying resources at the moments when most people don't really care about them. Then, gradually, you will have the opportunity to exchange them for capital or something else of value.

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