JEREMY GRANTHAM: SEVEN LEAN YEARS

An excellent read, as usual. I do not agree that the market is worth 850 (see US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!) , but all else is vintage Grantham. Read it all and more here.

My view of the economy’s future is boringly unchanged: “Seven Lean Years.” I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s.

In contrast to predicting the impossibly difficult real world, predicting market outcomes is relatively straightforward. Profit margins and P/E ratios always seem to pass through fair value if, and it’s a big if, you can just be patient enough.

(…)  But the bigger danger is that once again the Fed is playing with fire!
Whenever the Fed attempts to stimulate the economy by facilitating low rates and rapid money growth, the economy responds. But it does so reluctantly, whereas asset prices respond with enthusiasm. In our studies of the Presidential Cycle we have shown that, historically, where
modest Fed stimulus and some moral hazard hardly move the dial on the economy in the third year of the cycle, they  push stocks up almost 15% a year above normal and risky stocks even more. (…)

Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third go around in the bubble forming and breaking business.

Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty.

I do not regret the bailout, although half as much to bankers and more to people with hammers insulating roofs would have been better. With ships lining up by the hundreds outside Singapore harbor, unloaded for want of letters of credit and other basic financial services, our financial leaders had better have acted fast. And they did. Not efficiently. Not fairly. And certainly not frugally. But they thawed the global real world, which was freezing rapidly.

I thought in return for the pain we had all learned some lessons. I was naïve. Congress will probably stay in the pocket of the financial world, and few useful changes will  be made. Investors, traditionally reluctant to burn their fingers badly twice in a generation, line up to buy risk and bid down spreads as if eager to suffer for a third time in a decade. (…) Normally, investors appear to have longer memories than rabbits, but not this time! And the Fed, having learned nothing, still worships at the Greenspan altar. Overstimulus was painful in the 2000 break and extremely painful in 2008, but the Fed soldiers on with its failed strategy like Field Marshal Haig in World War I (“The machine gun is a much over-rated weapon.”).

So all investors should brace for the chance that speculation will continue for longer than would have seemed remotely possible six months ago. I thought last April that the market (S&P; 500) would scoot up to 1000 to 1100 on a typical relief rally. Now it seems likely to go through 1200 and possibly higher. The market, however, is worth only 850 or so; thus, any advance from here will make it once again seriously overpriced, although the high quality component is still relatively cheap. EAFE equities seem a little overpriced, emerging markets more so, and fixed income seems badly overpriced, especially cash, which is awful. Exhibit 2 shows our current 7-year forecasts.

The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful. Equity markets almost always peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities always ends badly. So this is a dilemma. In 2010, value purists will have to struggle increasingly with the Fed’s continued juicing of the markets. In order to control real risk – the risk of losing money – they will be forced to take the increasing  career and business risk of lagging a rising market. Our choice – by no means a “solution” – is to only very slightly underweight global equities on the grounds that, when tilted to quality, they are still adequate in terms of
return potential. We also have to swallow our distaste for parking the rest in unattractive fixed income. And if the equity markets are indeed driven higher in the next six months, which, unlike my view of last summer, now looks to be at least 50/50, we will very slowly withdraw
equities: eight times bitten, once shy, so to speak, for in these situations we typically beat a much too rapid and enthusiastic retreat. If we do see a substantially higher market in the next few months, we will probably underperform, but likely not by much.

There is perhaps, though, one saving grace: the risky stocks have already been driven to extreme overpricing. Further attempts to drive the market higher (they may not be deliberate attempts, but does it matter?) will probably result in a much broader advance in which high quality stocks should hold their own or even outperform. Believe it or not, they can outperform on the upside, and these times tend to be: later in bull markets, or when they are relatively cheaper than the rest of the market, or both. (More quantitatively, high quality stocks have outperformed in more than 40% of up months and approximately 60% of
the time when they were relatively very cheap, as they are now.) For the record, they also outperformed in 1929 and 1972, at the end of the first two great bull markets of the 20th century, and held level in 1999. In a continuing rally, even level pegging for quality would be a great
improvement over 2009. And, if the market surprises me and goes into an early setback in 2010, then quality stocks should outperform by a lot.

What could cause an early setback would be some random bunching up of
unpleasant seven-lean-years data: two or three bad news items in a week or two might do the trick. This would suit me – cheaper is always better – but given the Fed’s intractability, it seems less likely than some further gains. For the longer term, the outperformance of high quality
U.S. blue chips compared with the rest of U.S. stocks is, in my opinion, “nearly certain” (which phrase we at GMO traditionally define as more than a 90% probability).

GMO 7-Year Asset Class Return Forecasts*
As of December 31, 2009

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INTERNATIONAL LONG TERM INTEREST RATES

While long-term interest rates in the US are on the verge of breaking out to multi-month highs, a look at long term rates in other countries/regions shows that the rest of the world isn’t following suit.  As shown below, 10-year government bond rates in the US (3.60%) are currently well above the Euro region (3.25%) and Canada (3.42%) but still below UK rates (3.88%).

INTEREST rATES 121509

Bespoke Investment

 

High-Yield ETFs’ Love-Hate Relationship With Investors

(…) The high-yield boom has packed premiums onto ETFs that may not last. Inflows to high-yield ETFs have been virtually nonstop in the past few years. In order for new units to be created, third parties such as investment banks purchase the underlying bonds in the high-yield market, where transaction costs are high. But such banks will create units to sell to ETF managers only if it’s profitable, or when units are worth more than the cost of the bonds. When the high-yield market was nearly frozen in December 2008, high-yield ETFs traded at premiums of more than 10%, compared with about 1% in today’s healthier market.

What if inflows switch to outflows? As ETFs mature, marginal investor demand will likely decline, especially if the high-yield market falters. Just as investment banks buy bonds to create units, they sell bonds after redeeming units. If the bond market became illiquid again, trading costs would be steep. That could pressure ETF prices down to discounts before investment banks are willing to purchase and redeem units.(…)

Even so, high-yield ETFs offer better liquidity than investors likely can find elsewhere. When high-yield bond markets came to a standstill last year, the ETF market remained active and deep. Investors should just remember such perks don’t come for free.

Full WSJ article

 

DEBT ALARMS!

Budget deficits and rising debt levels are beginning to make headlines. Rating agencies need to rebuild reputations and will be speaking and acting early and harshly. This will have many ripple effects and unnerve investors at a time when most financial instruments are trading at elevated levels. Turbulance ahead, fasten your seat belt!

First, the Globe and Mail runs an article on sovereign risk and spiraling budget deficits (Charts from FT).

The enormous public cost of fighting the global crisis is haunting governments and unnerving investors.

image (…)  international ratings agencies sent shivers through markets with warnings that spiralling budget deficits and soaring debt levels are putting sovereign ratings at risk.(…)

Concerns encompass the U.S., Britain, France, Ireland, Portugal, Dubai and, most notably, deeply troubled Greece, whose credit rating was cut by one debt monitor and put on watch for a downgrade by another.

International ratings agencies are warning that other governments face similar actions if they don’t come up with plans to get their fiscal houses in order.(…)

“The issue for all of them [the Europeans and the U.S.] is that at some point one needs to see credible medium-term consolidation programs that will bring the debt back down again.”

Moody’s Investors Service said in a report Tuesday that the weakening public finances in the U.S. and Britain may “test the Aaa [triple-A] boundaries” for their ratings.(…)

But further worries about the euro zone risks and possible defaults in Dubai and by other heavy borrowers are sparking a new flight by jittery investors toward the perceived haven of the U.S. dollar and the deep U.S. Treasury market. The greenback rose Tuesday.

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Then Dennis Gartman raises an important question:

“If Greece is suffering such ill economic news, what possibility is there that the ECB will move in the foreseeable future to tighten interest rates?” That is THE question of the day, and the answer from our perspective is that despite all of the anti-inflationary rhetoric that comes
from the ECB, and despite all of the “hard money” philosophies that the monetary authorities in Frankfurt wish to spew, they cannot move to raise rates when conditions in Greece, or Ireland, or Spain, or Italy are
so desperate. Things may be going reasonably well in France, Belgium perhaps and even Germany, but things are going poorly indeed in these other “nations.” Germany may call for higher rates, but Greece cannot allow that, nor can Spain, nor can Ireland, nor can Italy and nor can most other “nations” of the EU.

This then brings us to the biggest of all questions that beset the Union: How serious are the divides between the member nations of the EU, and when will the ties that have bound Greece to Germany and Ireland to France begin to unravel? If unemployment is rising and debt ratings are falling in Greece, can Greece remain a member of the EU, or will street protests begin in earnest demanding either a split from Brussels or a change in how monetary policies are enacted within the Union? During times of plenty, all goes well of course; but during times of dissension, parties dissent:

(…) image the trend that has been in the EUR’s favour since March now seems to have been broken… definitively so. What had been a bull market has now ended, and where one previously had to buy weakness in the EUR one must henceforth sell strength. Where
one previous sold strength in the US dollar, one henceforth must buy weakness. When trends change… when WATERSHEDS occur… psychology and the manner in which one views things must change. We’ve witnessed a WATERSHED shift in sentiment, and so too must our trading philosophy change accordingly.

Remember Milton Friedman who, in 1999, predicted that the Eurozone would not survive its first economic crisis.

He issued this warning in the belief that, lacking labor and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy. In particular, he strongly believed that at a time of economic difficulty, there would be countries of significance in Europe that would have considerable trouble coping with the euro area’s one-size-fits-all approach to monetary and exchange rate policy.

Lastly and not very dissimilar, Moody’s downgraded Illinois. Gartman again:

Moody’s downgraded Illinois’ general obligation bond rating from A1 to A2 and cited Illinois’ problems stemming from the U.S. recession. Making matters worse, Moody’s also cut other Illinois bond ratings from A1 to
A2 including sales tax revenue bonds, also cut to A2 from A1. In the process, Moody’ has taken Illinois’ rating to the second lowest in the US, ranking it just above California Baa1. In so doing, Moody’s said that the
state has not yet taken action of any sort to deal with the budget gap that it is facing… a gap that Moody’s says shall be on the order of $11 billion, or more than one third of its total expenditures. Moody’s
said that the downgrades are the result of high structural imbalances and little time to effect modifications to the budget in the current fiscal year, which ends June 30, 2010, as well as evidence of significant weakening in the state’s 2009 results.

The problem here is not just one that Illinois is suffering through, for if Illinois, with a double digit unemployment rate is downgraded, what then of Michigan; what then of Nevada; what then of Ohio perhaps? The point here is that “There is never just one cockroach.” This problem in California, now in Illinois, is going to spread to other states very, very quickly, for once Moody’s has the courage to make the credit change there, it will be swift to make the same changes to the credit ratings of these other states too. It is but a matter of time.

Too, now that Moody’s has moved on this issue, the other ratings agencies will have no choice but to follow.

 

SOMETHING HAS TO GIVE

Three commentators discuss the same phenomenon:

OVER THE PAST DECADE, stock and bond prices have generally moved in opposite directions, meaning that share prices and bond yields have moved together, both higher and lower.(…)

This important relationship held true this year until June, when bond yields peaked. One month later, as yields moved lower, stocks began their current leg up.(…)

Given their relationship at major turning points over the years, something is not quite right. And when it comes to trusting bonds or stocks for the correct "opinion," history would suggest that it’s usually better to go with bonds.(…)

One part of the bond market caught my eye this week. The yield on two-year Treasury notes fell nearly 40% to an unreal low of 0.67% and is just a hair from its generational low of one year ago.

[Getting Tech chart]


This is important for two reasons. The first is that one year ago, the financial markets were nearly frozen and investors looked for the safest places possible to park their money. Treasury securities with short maturities were the only assets that were holding their value and demand to own them pushed prices up and yields way down.

The second reason is that the yield on the two-year note joined three-month bills in approaching zero again. Longer dated Treasury yields, from five years to 30 years, are not even close to reaching respective 2008 lows and that suggests that some money is moving towards an extreme safety position again.(…)

Full Barron’s article

And David Rosenberg

The U.S. 10-year Treasury note yield gapped above the 50-day moving average yesterday. In the past six months we have been in a most unusual backdrop: bond prices up, equity prices up, oil prices up and gold prices up. Looking back at the historical record, this is what you call a 1-in-15 event. In other words, not normal, and something has to give.

In the past, it has been Mr. Bond, shaken and stirred, that has been the arbiter of realigning the asset mix. (…)

The odd man out here is clearly the bond, but if yields head back up to 4% (about 50% of the rally in the 10-year note has just been retraced in this recent spasm in yield), expect a countertrend rally in the U.S. dollar over the near-term and a giveback in all these risky assets that all of sudden become 90% correlated with the greenback.

As for the vast amount of supply we mentioned above, well, the U.S. Treasury is going to auction — get this — $105 billion in Treasury bills and notes next week. Talk about choking on the wishbone. This fiscal largesse may come at a pretty big cost and aside from a countertrend rally in the U.S. dollar (as Mr. Trichet is pushing for) a further yield spasm in the Treasury market at a time when the economy is still struggling (ISM services back below 50 — that is not good) could well be enough to upset the equity market apple cart; just as investors are closing their books as the year draws to a close. Buying some protection, especially now that it is cheap, may not be a bad idea.

Tony Boeckh adds

The last nine months have been a remarkable period in that equities, gold and corporate bonds have all appreciated by double digits. This has only occurred on two other occasions in the last 50 years. Typically, equities perform best during periods of low and stable inflation, like the current environment. Gold (and other commodities) performs best during inflationary periods and when the dollar is weak, while government bonds tend to outperform during periods of deflation and risk aversion. The current, unusual dynamic where almost everything has gone up together cannot last forever.(…)

The current environment diverges from the typical cycle in that easy policy is not translating into domestic consumer or business credit expansion.

 

Risks, Hedges and Opportunities

The cost of money is so low that no matter what view an investor may have, there is enough money around to be right over the short term.

Players that are deploying a defensive investment strategy either by buying deflation related trades like bonds or inflation related trades like gold are winning. I argued, last week, that gold is due for a 20% price reduction. By the same token, treasury yields are subject to a similar upward correction.

As of November 27, 2009 ten year US treasuries were yielding 3.25%. A decomposition of this rate reveals that the US economy is not likely to increase much more than 1.25% per year on the long term with an inflationary factor of 2.00%. As an historical rule, US treasury yields have for most part averaged 80% of the growth of nominal GDP. It’s interesting to note that nominal GDP should decrease 1.55% in 2009 and increase by as much as 4.00% and 4.25% respectively in 2010 and 2011. Accordingly, actual treasury yields are bang on with fundamental, equilibrium and fair value.

However, investors are receiving absolutely no compensation for any fiscal risks. The Treasury market is priced for perfection believing that the ‘sweet spot’ created by the quantitative and near zero monetary policies of the central bank plus the collapse of credit demand by the private sector and benign inflation will last for a long time. Like gold, there is a huge disconnect here.

Forward-looking bond participants are not considering the possibility that strong headwinds of large debt burden, huge deficit financing and un-relented currency depreciation could bring about responsive money management and/or earlier rate hike by the FRB. Investors cannot hope on huge household savings, albeit much better than it has been for years, to bail out the government.

Based on the recent performance of leading indicators, a 5.00% increase in nominal GDP is not out of the question. A circumstance that would certainly stop QE, raise bank credit demand and increase target rates a few notches forcing yields on ten year treasury notes toward 4.25%. Defensive plays like the purchase of treasuries are good insurances against deflation, but current premiums are expansive for they are not automatically "risk free’. The FED may not believe that an exit strategy is yet warranted. Nevertheless, investors should have one because it may come sooner than expected and it would then be too late to smartly react.

We will always hold bonds for insurance in all of our funds but a lot less than we used to own. Keep a close watch on the weekly ECRI Leading index. It increased to 128.8 for the week ended November 20 for an annualized growth rate of 24.1%. A significant improvement since the bottoming out of last March. The Great Recession ended in late July.

Hubert Marleau, Chief Investment Officer, Palos Management Inc.

 

A PRIMER ON BONDS AT EXIT?

THE GREEKS WERE EARLY in so many areas — republicanism, competitive sports, spinach-and-feta omelettes. There’s a chance that recent action in Greek government bonds is offering an early glimpse at the anxiety that could attend the eventual withdrawal of central banks’ "extraordinary efforts" to lubricate the capital markets.

Spreads on Greek government bonds have blown higher, far beyond anything experienced in other European sovereign-debt markets. As the European Central Bank has made noises about unwinding some of its support programs, Greek government debt has been sold off hard, largely by Greek banks, which own a lot of it and have been posting it as collateral to borrow from the ECB.

Greece’s finances are about the most overextended in the EU. Its fiscal deficit this year is projected at 12.7% — almost the same as the U.S., incidentally.

This action is probably best placed in the Worth Noting file, rather than the Panic Now dossier. And it’s an illustration, perhaps, of why the U.S. Federal Reserve is likelier to err on the side of slow, rather than pre-emptive, withdrawal of its heroic liquidity programs.

Barron’s

About Greece’s economic situation:

(…) As the country’s budget deficit swells, its sovereign credit rating has come under renewed threat. That has encouraged speculation that Greek government bonds might soon no longer be accepted as collateral by the E.C.B., or might only be eligible at a higher cost.

All of this has unsettled investors, who marked down the price of Greek bank shares early this week and are again demanding a bigger premium to hold the country’s debt.(…)

Full NYT article

 

SOME THOUGHTS ON CREDIT … AND THE DOLLAR

David Rosenberg has some interesting observations on the strange correlations recently observed in financial markets:

Still bullish on credit spreads

Baa spreads (Baa corporate yield minus U.S. 10-year Treasury note yield) have consolidated around 290bps — there has been very little spread tightening over the past month, more or less in line with the plateauing in the S&P; 500 around the 1,100 level.

Based on a good hard look at history, if we were to see a double-dip recession, the potential for spread widening would likely be limited to 380bps or 90bps wider than they are today.

If we can avoid a double dip recession, even if we see sluggish but positive growth, spreads, at a minimum, would stay where they are. But it should be noted that in the absence of recession, there has never been a period of expanding economic growth, no matter how mild, that Baa spreads failed to test 150bps.

Amazing new correlations


If there is a non-economic risk, it comes down to the U.S. dollar, and Nouriel Roubini is probably onto something in the sense that it has become a huge ‘carry trade’ vehicle for all risky assets. Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P; 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The bear U.S. dollar trade is very crowded right now. Mr. Bernanke mentioned the dollar’s weakness yesterday as a possible source of concern — it is very rare to see that from the Fed. It’s hard to know what the catalyst for a near-term counter-trend rally would be (one catalyst could be an “event” in China, and for an example, see Big Property Bubble Forming in China, Warns Leading Developer on the front page of today’s FT) but that is a primary near-term risk and the only reason I can see for keeping our powder dry. Recall that in the fall of 1987, it was a sharply weaker (and disorderly) U.S. dollar in the aftermath of the failed Louvre Accord that ultimately touched off the crash (Baa spreads widened over 100bps in a week — despite GDP growth of over 7%). So, big and sudden moves in the U.S. dollar have in the past been a catalyst for big market moves and something that has to be taken into consideration if we are looking at all into raising our risk profile/leverage in this space.

We also re-ran some regressions on Baa spreads:
•If we double-dip we get to 400bps
•If we get the consensus call of 2.5% GDP growth, we stay the same at 290bps
•If we luck into 4.0% GDP growth, spreads tighten to 190bps.

As I mentioned yesterday, the range of possibilities is wide, but base case is that we shouldn’t deviate too far from where we are based on the economy going forward and this is still a nice spread for U.S. investment grade product. Key non-economic risk is the U.S. dollar bouncing back, which screws up the carry trades. The core PPI number was a reminder that deflation is still in play outside of commodities; and Bernanke hinted strongly that the Fed is not touching rates for a long, long time, and bear phases in bonds don’t start until the market begins to price in the tightening cycle.