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I can probably elaborate on any part of it, although I'm not sure what you're looking for or what good it will do. In any case, what I'm finding most fascinating nowadays is wondering how many Wall Street quants are running around in a panic trying to hedge their exposed interest rate and credit risks. Ditto for the GSE's (or at least FNM).

All that's been pretty well picked over, although did anyone else find it strange that Moody's ostensibly downgraded JPM because of job cuts possibly hampering their profitability when the economy turns around? I've not heard of such reasoning before. Sounded to me like they were trying to send a coded warning without alerting the general public.

I guess (as long as I'm rambling) that the one thing that concerns me is using models of company performance that are predicated on economic conditions returning to normal in a year or two. Just so you know what kind of advice you're paying for, I've only been investing for 6 years and two of those years were all about indexing, so my perception of an economy is heavily weighted towards the recent past. I've tried to compensate for that by reading about historical market events but that doesn't quite do it justice. Just as an example of how nothing substitutes for experience, during the height of the market in late '99, early '00 I was aware that the dot-com market was overvalued and would eventually come down, but I extrapolated that to other areas of the market and was hesitant to invest in almost anything. Subsequent events (and probably the results of many here) showed that there was plenty of value if you stayed in the right areas, and it was a mistake to link the fortunes of overvalued stocks with that of fairly or under-valued ones. That kind of lesson doesn't really come through in a book but it can have an important impact on your returns.

In any case, I think there's a real risk of an economic dislocation that could be triggered either by a deflating consumer, declining real estate values, a disruption in credit markets and a liquidity crunch, departure of large amounts of foreign capital, rising interest rates or (most likely) some combination of the above. Unless we get a shock (such as J.P. Morgan or Fannie Mae becoming insolvent) my implicit assumption is that these things unfold slowly in fits and starts. The long-term result will be that business activity will return and companies will continue to profit, but at a lower level, sort of an 'L' shaped economy.

I hate sounding like a Chicken Little, but every so often the sky darkens, the clouds open up and it just pours. We know it does, there's just no common sense in thinking otherwise. We just don't know if it's happening now. Last time was in the 30's, and even Ben Graham had a hard time keeping afloat during the worst of it if I recall correctly. The point of this is not to scare or start a gloom and doom fest, but basically to state that it makes sense to leave some flexibility in your model such that it incorporates outlying probabilities and doesn't depend on a return to economic levels of the late '90's.

To give an example, I'm struggling with trying to come up with a 'goldilocks' estimate of revenues in my analysis of a particular company right now - that is, not too optimistic but not too pessimistic. It's not retail, so this won't fully apply, but I'm leaning towards assuming a run rate equal to about 1995-96 revenues which is above where they are now, but not by much. Of course in 1996 this company did quite well, even in the face of a downturn, but with a shift in business strategy and more employees, fixed costs are about double what they were and I don't anticipate management would be able to cut all that out even if they wanted to. These and a few other assumptions have a very significant impact on the company's value going forward, as it still appears overvalued to me. Looking in the rear-view mirror though, it looks highly undervalued, even throwing out 2000, which was just a freakishly good year. Which model will turn out to be right? Darned if I know, but I'd rather hang on to what I have, because even if things don't get as bad as I think they might, there'll be other opportunities in the future.

I hope this elaboration helps somewhat – it's more subjective than my first reply because I generally prefer not to color other people's analyses with my biases, but you did ask. Anyway, after all of that, I think I've come up with another even better way to state it: “margin of safety”.

Chris
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