Defying Gravity and Other Hurdles

 | Apr 30, 2013 | 5:00 PM EDT
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Since the financial crisis of 2008, interest rates and bond yields have declined -- sovereigns and corporates, short and long term -- as well as investment grade and junk.

With the decline in bond yields has come a decline in spreads between short-term and long-term debt. This is most obvious in the decline in the difference between the 2- year and 10-year treasury yield from about 250 basis points to about 150 today.

The 2-10-year treasury spread and its difference over time is used as a proxy for estimating the trajectory for the profitability of the insurance industry in general.

I've written numerous columns on this subject, advising of the negative consequences of a flattening yield curve and a shrinking spread  on the profitability of insurance operations  -- and logically on the share price of stocks in the sector.

Regardless of how sound the logic has been -- and historically supported  -- the expected results have been the exact opposite: Insurance stocks just keep slowly increasing in price even as the fundamental economic and financial headwinds continue to mount.

No company better epitomizes this trend than Berkshire Hathaway Inc. (BRK.B) (BRK.A). Although Berkshire is better categorized as a conglomerate, its cash cow has always been its insurance operations and comparing it to others in the sector is warranted. 

The stock price has more than doubled from the March 2009 crisis lows -- an average annual increase of almost 20%. It has increased 23%  since the Fed announced QE3 last September and QE4 last December, both designed to shrink short-to long-bond spreads even further.

The old saying "don't fight the Fed" takes on a new dimension with this stock.

Although lowering the costs of debt capital may be good for the economy overall, and most business sectors, it's a direct attack on the profitability of traditional "borrow short, lend long" insurance models. I don't know how long investors in the insurance sector, and especially Berkshire, can ignore this fact, or simply be unaware of it. 

Some stocks in the insurance sector have benefitted from the Fed's moves, however, as investors have sought dividend paying stocks to make up for the income they can no longer get in bonds.

Although this is logically a contributing factor for investors' interest in insurance companies, Berkshire is the only major insurance company in the U.S. that doesn't pay a dividend, so it's not an issue for investors. American International Group (AIG) also doesn't pay a dividend, but that is a unique situation.

Berkshire has been benefitting from the perception of safety investors have bestowed upon the stock and the company's prospects regardless of the economic environment. In some ways that can be self validating as it makes the value of Berkshire's currency -- its stock -- worth more than others. It also provides them with an advantage in buying other companies and in growing their business away from dependence on insurance.

Berkshire Chairman Warren Buffett warned investors about a year ago, after terrible fourth quarter 2011 earnings were announced, that the company's insurance operations would no longer be a source of growth.

Investors ignored both the dismal earnings and Buffett's warnings and have bid up the stock 33% since, from about $120,000 to $160,000.

It doesn't make sense to me.

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