Warren Buffett is the best investor of our time so it pays to follow his direction. Besides individual companies, Mr. Buffett has been busy buying stocks since the market bottomed in late 2002 and early 2003. At the end of 2002 Berkshire Hathaway owned stock worth $27.9 billion. By the end of 2006 the figure had grown to $52.8 billion -much more than accounted for by appreciation alone.

Even more interesting is what he’s been buying. True to his contrary nature all of his major purchases have been large capitalization stocks that have been out-of-favor with investors. Stocks that are new positions since 2002 and are near or above $1 billion in value include: Anheuser Busch, ConocoPhillips, Johnson & Johnson, Wal-Mart, and US Bancorp.

There was good reason to be cautious in the Spring of 2006: (1) deterioration in the housing market; (2) rising interest rates; (3) shrinking global liquidity, especially Bank of Japan’s move to absorb excess yen; (4) increased volatility in earnings and stock prices during 1Q2006 earnings season; (5) poor employment data plus tepid wage gain figures; (6) high commodity prices; and (7) sticky and elevated inflation.

It seemed like a high-probability event that the housing woes would finally hurt the consumer, corporate profitability would revert to the mean and decline, and valuations of stocks would contract along with the fundamentals. However, these outcomes did not develop, and, in fact, many bullish events played out.

Most importantly, the housing debacle was contained and did not spill over into the broad economy. And just as important, the Bank of Japan backed away from their effort to drain liquidity from the world economy. Despite short-term interest rates moving up to 5.25%, long-term interest rates declined dramatically from 5.5% to 4.5%. Oil fell below $50 a barrel. Rising stock prices helped offset the damage of the housing bust. All three of these events kept the consumer going. As a result, corporate earnings were solid in the second half of 2006. The government discovered that many more jobs had been created than originally thought. Plus, workers were finally seeing meaningful wage increases without a corresponding rise in inflation, which itself was showing signs of moderating. Finally, private equity became a major player in the stock market providing both a psychological boost to investors as well as a floor to stock prices.

Bottom line: the risks were real but fortunately they did not come to fruition.

Over the past few years bullish economists supported their viewpoint using “average” data while bearish economists relied on “median” data. Median measures give the best picture of what is happening to the middle class because, unlike mean or average wages, median wages are not pulled upwards by rapid gains at the top. As the joke goes: Bill Gates walks into a bar and, on average, everyone there becomes a millionaire. But the median does not change. 

Over the past few years the economy has been very good to the rich, but most data has overstated the benefit to working-class America. However, recent trends are encouraging. After four years in which pay failed to keep pace with price increases, wages for most American workers have begun rising significantly faster than inflation. Now investors need to keep a watch to make sure higher wages don’t result in higher inflation or lower corporate profits.

As we commented in our letter that accompanied our client’s performance reports economic data during the past year has been mixed and at times contradictory. If you are bullish, there is plenty of positive data; if you are bearish, there is plenty of negative data. We find it is useful to look at tax data to break the tie – clearly nobody pays more taxes than they have to. The message here is that the economy is strong. Tax receipts were up 11.8% in fiscal year 2006 (FY06) on top of FY05’s 14.6% increase. Receipts have grown another 8% percent so far in FY07. At the same time, however, state sales tax collections have been weak. So even the tax data has contradictions! 

Our interpretation of these facts is that the housing recession is being reflected in more modest consumer spending (for middle class and low-income America) but its negative effects are contained and have not spread to the broader economy. This environment is bullish for companies focused on high-income customers and companies with substantial overseas business.