While hardly saying something that we have not mentioned at least once in the past four years, Jeremy Grantham's latest letter is worthy read if for no other reason because it is encouraging to see that despite the relentless creep of Bernanke's madenning central planning regime, the smartest people in the room still haven't lost sight of the big picture.
Key highlights:
all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome!
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it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one.
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I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating!
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a) if we in the U.S. don’t invest, others will and it will, in the longer run, definitely end badly; b) that even if there is a lower-return world in the future it is still better to own the cheaper assets; and c) it behooves buyers of “cap rate” type assets like real estate to realize that the current low rates are flattered by current Fed policy, which will, like everything else in life, pass away one day, leaving them looking overpriced. It can’t be too soon for me.
And some more:
The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time. This low interest rate period is serving, therefore, as a sneak preview of what a permanently lower rate regime might look like (although any permanently lower rates reflecting lower GDP growth would be by no means as low as these engineered rates that we are currently experiencing). So what are some of these effects? The artificially low T-Bill rates first work their way slowly up the curve. Next, the most obviously competitive type of equities – high yield stocks – begin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea. Then, this low rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap rates” slowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise. The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost. Then, if the heart of capitalism is still beating at all, a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets – houses or stocks or both – far over replacement value, followed eventually, at long and hard-to-predict intervals, by exciting crashes. No way to run a ship, but it does produce an environment that contrarians like us, who can take a few licks, can thrive in.)
The normal capitalistic response described above runs smack into the new tendency for corporations to either sit on money or buy stock back (regardless of how expensive it may be!), which works in the opposite direction to create shortages, drive prices up, and, as a by-product, lower job creation and GDP growth. So where does this all come out? You tell me. All that I know is: a) if we in the U.S. don’t invest, others will and it will, in the longer run, definitely end badly; b) that even if there is a lower-return world in the future it is still better to own the cheaper assets; and c) it behooves buyers of “cap rate” type assets like real estate to realize that the current low rates are flattered by current Fed policy, which will, like everything else in life, pass away one day, leaving them looking overpriced. It can’t be too soon for me. In the meantime for us at GMO it means emphasizing care and maintaining a heightened sense of value discipline, not only in stock selection, as the whole world is once again bid up over fair value in a way so typical of the post 1994 era, but also in forestry and farmland. GMO has investments in those areas too and recognizes the need to sidestep overpricing by emphasizing the nooks and crannies. Fortunately there are more nooks and deeper crannies in forests and farmland than there are in almost any other area, certainly including stocks.
This doesn’t really fit in with a quarterly letter emphasizing important good news, but being about the Fed, I have to make an exception. The Fed appears to be still assuming a 3% growth rate for future U.S. GDP. It would be safer and more confidence-inspiring, now that Bernanke appears to take his responsibility for growth seriously, that he at least have a reasonable growth target (preposterous as that notion is to me that the Fed should or even could affect long-term growth simply by messing about with interest rates). The growth in available man-hours has definitely declined by about 1% a year, yet Bernanke’s assumption for our GDP’s normal trend growth appears unchanged at its old 3%. Ergo, he must be assuming an offsetting rise of 1% in productivity. But why? We should treat these assumptions quite seriously for this is famously (for me) and painfully (for all of us) the man who could not see a 3¾-standard-deviation housing market, and indeed protested that all was normal, etc., etc., etc. (Dear handful of niggling readers, this 3¾-standard-deviation event is calculated on the assumption of a normal distribution, as is often done in investing, even though we [especially at GMO] know this is not true but is just a convenient statistical device. In fact, we at GMO know quite a bit more on this topic for we have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330 “bubbles,” 36 of which we call “major, important bubbles,” which we define as 2-standard-deviation events, given the same assumption. Well, a 2-sigma event should occur every 44 years in a normally distributed world and they have occurred every 31 years. This is much closer to random than we had previously thought. Yes, financial asset data is fat-tailed; that is, there are more outlying events than are found in a normally distributed series, but they are not extremely fat-tailed. They show up as 2-sigma events but occur as often as 1.8-sigma events would occur in normal distributions. Extrapolating, we can assume that Bernanke’s 3¾-sigma housing bubble would occur, adjusted for our fat-tailed real-life history, not every 10,000 years, but somewhere more like 1 in 5,000 years! I previously used “a 1-in-1,200-year event” as a casually selected very large number to describe the 2006 housing bubble. But under challenge, these current numbers are more accurate. No, this does not mean we have 10,000 years of data or even 5,000. It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one. I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating! Fine-tuning economic growth, an impossible job for the Fed anyway, is hardly likely to get any easier by badly overstating trend-line growth. It seems nearly certain, therefore, that the Fed will keep trying to whack the donkey for far too long. The likely consequences of this policy are, to be frank, over my head, but my colleague Edward Chancellor will address them briefly if I can nag him effectively.
Courtesy of the above Fed policy, all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome! But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced. European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced. Notably, U.S. stocks (ex “quality”) now sell at a negative seven-year imputed return on our numbers and most global growth stocks are close to zero expected return. As for fixed income – fugetaboutit! Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occurs – accelerating inflation.
When one combines the apparent determination and influence of those who do the bullying with the career risk and short-termism of the bullied and the desire of the general public to believe unbelievable good news, these overpricings can go much further and the Fed can win another round or two. That’s the problem. A clue to timing would be when we begin to hear more passionate new era arguments: profit margins will always be higher; growth will snap back to 3% for the developed world; and new ones I can’t think of … maybe “when the discount rate is this low the Dow should sell at, perhaps, 36,000.” In the meantime, prudent managers should be increasingly careful. Same ole, same ole.
Full letter: