This Week In Finance

"Expectations, El Nino, and Warren Buffett"

Finance is often called the "science of valuation," and, as we all know, the expectations of market participants about the size, timing, and risk of future cash flows determines security values today. Here's a tip for your lecture on the complex relationship between investor expectations and bond prices, which involves global weather patterns, Warren Buffett, and Wall Street rumors.

Last week, the headline in Monday's "Credit Markets" column was "Bond Forecast Clouded by El Nino." For a two or three day span, financial journalists and pundits issued dire predictions about upcoming weather patterns. But how does this relate to bond prices? And where does Warren Buffett fit in here?

Water temperatures in the Pacific Ocean near the equator have been rising, and weather patterns have affected, according to scientists. This is the "El Nino event." And according to The WSJ story, "[E]xperts say this El Nino may become the strongest of this century, capable of wreaking havoc with weather patterns for the next year and maybe longer."

Further, prices in commodity markets "have been roiled as reverberations from El Nino trigger price rallies." And it's a short (some might say, a "Fisherian") step from there to begin to consider the possible effects on investors' inflationary expectations, and, subsequently, required returns.*

Sounds bad for the bond market, eh? Then consider the "Credit Markets" tag line on September 15: "Bond Bulls, rejoice: You've got good company. Berkshire Hathaway, run by renowned investor Warren Buffett, has been a big buyer of bonds in the past month. . ." Further, the article notes that Berskshire has bought spent nearly $10 billion (face) on bonds in the last five weeks. (!)

"Talk that Buffett has been buying is a real factor in the bond market in the last month," one trader is quoted as saying. If the world's most famous investor is buying this heavily, he must feel that market interest rates and, presumably, inflation will not be rising soon, right? Mr. Buffett "seems to be betting that the U.S. economy will remain in a low inflationary environment," according to the article's author.

What's the upshot of this? Assuming one attributes Mr. Buffett's incredible investment success over the last three decades to skill, knowledge, business acumen, and/or access to information, rational investors would take his actions into account when forming their own expectations about the future direction of bond prices and inflation.

In any event, the last week has produced two news items that should be major influences on investor expectations, albeit in opposite directions. What lessons might students draw from this?

1. Market prices (and required returns) do indeed react rapidly to new information.

2. The links between real-world events and changes in investor expectations are not always (not ever?) clear, which keeps investors guessing and market strategists employed.

3. The effect of information on investor expectations about future cash flows, not the information per se, that is important in the valuation sense.