#-ad_banner-#Back in February, I took a close look at Warren Buffett’s $12 billion stake in Wells Fargo (NYSE: WFC).

Well, it’s now more like a $10 billion position. He hasn’t sold shares, but the bank’s stock has been steadily dropping, giving the Oracle of Omaha a rare black eye. To understand Buffett’s next move with this massive banking concern, you need to understand why shares are marching backward.

The long-term view
Buffett didn’t simply start acquiring shares in recent quarters. He’s been doing so for a number of years. But you could argue that his long-term bullishness has been a bit misplaced, or at least a bit premature. He steadily bought Wells Fargo shares in the middle of the last decade, despite signs the housing sector was starting to overheat. More recently, he bought a lot of stock last fall and winter on hopes the U.S. economy was on the cusp of a broad-based upturn. As a result, his buying binges in 2007 and again in late 2010 took place in the low $30s, above the current price.

 
The appeal to Buffett
Buffett’s recent buying spree could be attributed to one of two factors. Either he believed the bank was on far healthier footing than more bearish investors had been assuming, or he figured the economy was about to kick into a higher gear, boosting lending activity among businesses and consumers.

On the first count, he was absolutely right. First-quarter results showed a continued improvement in loan loss reserves and other credit quality measures. The prospect of another banking crisis for Wells Fargo and its healthiest peers is simply off the table at this point.

But Buffett would have been wrong to assume the economy in general and Wells Fargo in particular are on the cusp of a major upturn in activity. First-quarter results showed a bank that is all revved up with no place to go. Ample levels of capital are parked on the balance sheet, since lending activity remains very slow. The fact that Wells Fargo has begun a $200 million stock buyback is less appealing than you might think. The bank would clearly rather put that money into more productive uses such as loans that bring high profit spreads. In fact, recent economic data points imply that the rest of 2011 could be fairly uninspiring as well.

Analysts at Citigroup estimate Wells Fargo has $100 billion of excess liquidity that would be available for loans in a more robust economic environment. But in these slow times, that capital base is earning just 0.29% in net profit spreads.

So what will get shares going? A clear and steady economic upturn allowing Wells Fargo and its peers to put their money to work. “Bank investors continue to focus on the lack of balance sheet leverage as the economy improves,” write analysts at Goldman Sachs. Yet while that may not happen for a number of quarters, they still think the stock is appealing now below $30, citing a rising dividend, the stock buybacks and a belief that Wells Fargo is “well-positioned to pick up loan market share.” In effect, bank lending may remain weak in the near-term, but Wells Fargo should continue to show its competitive advantages. That’s why Buffett grew so enamored with Wells Fargo in the first place.

Action to Take –> It may be too soon to draw negative conclusions from the recent economic slowdown. Many thought the U.S. economy was headed for fresh troubles in the summer of 2010, but the negative tone to economic reports proved only temporary. This time around, we may have just hit a temporary rough stretch once again.

If the economy has indeed hit a longer-term speed bump, then Wells Fargo’s shares are still likely to hold up in the mid- to upper $20s, thanks to a superstrong balance sheet and share buybacks. If the economic rough patch is only temporary, then shares could quickly move back up to the 52-week high near $34 and then power past that level.

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