“By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.”

That’s how Warren Buffett describes the recent market carnage in his recent 2008 annual letter to Berkshire Hathaway shareholders.

You can’t fault the Oracle of Omaha for using such a grim metaphor. After all, Buffett just recorded his worst annual performance in 44 years at the helm of Berkshire. And as he goes on to point out, there have been relatively few places to hide throughout this downturn. Muni bonds, real estate, stocks, many commodities … all have gotten hammered relentlessly.

A lot of mainstream pundits have jumped all over Buffett lately. They’ve declared him a hypocrite because Berkshire sold stocks despite Buffett’s New York Times Op-Ed recommending investors “buy American.” They’ve lampooned his choice to make derivatives bets on major stock indexes. Some have declared — yet again — that Buffett has lost his touch.

I’m not here today to defend Buffett; though I will point out that every bout of anti-Buffett squawking has ended up looking foolish in retrospect. Moreover, the guy has grown his investment company’s book value by 20.3% compounded annually, even after the latest downturn!

My point is simply that no matter what you think of Buffett, he is still worth listening to. And that’s why I want to talk a little more about what he said in his annual letter to shareholders.

Let’s start with another grim truth …

“Like it or not, the inhabitants of Wall Street, Main Street and the various side streets of America were all in the same boat.”

I certainly DO NOT like the bailouts. As a responsible saver and investor — someone who sat on the sidelines throughout the obvious housing bubble — I can’t stand the fact that my tax dollars are now going to help people who let greed drive their poor choices.

And for the record, I consider unqualified home buyers AND lenders equally guilty.

But the money floodgates have already been opened. So the only logical question left is, “What are the long-term consequences?”

Buffett’s answer …

“Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”

This echoes a point I’ve been making in recent Money and Markets columns.

Deflation is in the driver’s seat at the moment, and cash has been king. And there’s no telling how long the trend will last.

But when things do turn, I believe the central banks will remain behind the curve as they have all along.

That means renewed inflation, possibly substantial inflation.

In other words, now is the time to consider inflation protection, which is why I’ve been singing the praises of inflation-protected bonds as well as dividend stocks right here in Money and Markets.

Now, you might wonder why I continue to suggest investors stay the course in quality dividend stocks even throughout these horrible times.

It’s because, as Buffett reminds us …

“Our country has faced far worse travails in the past … Without fail, however, we’ve overcome them.”

The jobs numbers have been horrible. Housing has more downside ahead of it. Global GDP is set to drop sharply.

Buffett remains confident in the resiliency of the U.S. economy … and so do I.

Yet I continue to believe that the U.S. is a land of optimists. A place where — even now — plenty of people are finding ways to profit and prosper. And I don’t think any amount of economic damage will dampen our collective entrepreneurial spirit.

Is this the bottom for stocks? There’s no way to know. When will the recession end? Again, there’s no way to predict it.

Regardless, I don’t think this is the end of our great economic machine. Nor do I think all stocks should be trading at doomsday-scenario prices.

For example, Buffett’s letter points out that two of Berkshire’s largest operations — utilities and insurance — remain economically insensitive, and delivered strong results in 2008.

Right now, investors don’t seem to care. They’re selling everything and asking questions later.

This is precisely why I continue to recommend a bunch of utilities in Dividend Superstars. It is why I recently recommended a niche insurance company that has been unfairly punished. And why I tell my subscribers to hold on to many quality companies even as their share prices dip lower.

Because, in Buffett’s words …

“When investing, pessimism is your friend, euphoria the enemy … Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

If you believe in that philosophy, then this is the time to consider dipping a toe in the water. Heck, I have never seen such widespread pessimism!

Some of it is well founded, to be sure. We are in for a real uphill battle.

If you feel uncomfortable with the risk, I understand. You should do what allows you to sleep at night.

However, if you want stocks in your portfolio … if you have some money you can afford to risk … or if you have time on your side, I think you should consider averaging into some positions here and there.

Especially since many of the other alternatives look completely unattractive right now.

In fact, that’s the one last major thing that Buffett and I agree on. As he says …

“When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

Many of us at Money and Markets have been saying longer-term Treasuries look mighty dangerous at these levels.

They are paying very little in interest. Plus, they could fall very suddenly if investors decide to stop loaning “free” money to the U.S. government.

The irony is that Treasuries are considered the safe investments right now … the only place where losses can’t happen. I think that’s precisely what makes them dangerous.

Bottom line: I don’t think Buffett is infallible. Nor do I agree with every single thing he says or does.

But I can’t argue with any of his major conclusions in the latest annual letter to Berkshire shareholders. It jibes completely with the approach I’m advocating right now …

First, don’t expect miracles but don’t give up on quality stocks, either.

Second, prepare for the possibility of resurfacing inflation with protective investments like TIPS.

Third, stick to short-term Treasuries for your “keep-safe” funds.

Sound boring? Maybe it is. But as Buffett says in his letter: “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

Best wishes,

Nilus

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