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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Risks, Hedges and Opportunities

There is no escaping that monetary policy is a very complex subject matter, difficult to apply and much more than a simple idea of targeting an appropriate inflation rate. The monetary authorities are not innocent for they can easily make mistakes and clearly bear a lot of responsibilities for the consequences of their policies on the behaviour of the financial markets and economic activity.

On the one hand, should the monetary stance be easy at a time when it is tight, market prices of risky assets would rise, government bond yields would increase, the value of the home currency would decrease in term of gold, and inflationary expectations would increase. On the other hand, should the monetary stance be tight at a time when it is easy, market prices of risky assets would decline, government bond yields would decrease, the value of the home currency would increase in gold terms, and inflationary expectations would decrease. Of course, the longer the conduct of monetary policy, and the more far away it is from what it ought to be, the more dramatic will the unintended consequences be.

To properly judge the effect of monetary policy on things that matter to investors, one must know and understand that monetary policy is not asymmetric but somewhat chaotic. A much better way to judge which monetary stance the central bank should conduct is to have the common sense of taking a more macro economic approach.

Based on historical repetition, monetary policy should be neutral when prices are stable, fiscal budgets are in balance, the balance of payments is viable, employment is full and economic growth in nominal terms equals closely, population and productivity changes. There is ample empirical evidence and theoretical validity that for any given deviation in the above factors it should tilt the monetary stance away from even keel. If it`s not done, the Central Bank is not counteracting the pro-cyclical forces of finance, thus creating risks or opportunities to investors.

Palos Management’s US monetary policy index which takes into account all of the aforementioned factors calculates that the monetary stance of the US Fed should be slightly on the tight side of even keel. On January 22, 2010 the index stood at 115. Neutral is 100 and less than 100 is easy. Yet, the US monetary stance is clearly easy for the yield curve is steep, the federal fund rate is way below the rate of inflation and the FRB has flooded the banking system with a massive expansion of the monetary base. If it had not been that the economy was in the throes of writing down huge amounts of bad debts, the money supply (MZM) would have doubled.

Theory predicted correctly the debasement of the US dollar in gold terms, the surge in the market prices of risky assets, the rise in government bond yields and the increase in inflationary expectations in 2009 and the early weeks of 2010. The question is will the monetary stance of the FED turn in 2010. If the FED does not, more of the same can be expected. But, should it adopt a tighter stance, as we believe it will, than a more sober market for risky assets, a more stable US dollar and more increases in government bond yields can be expected.

Consequently, the beginning of the exit from super-expansionary monetary policies will be one of three dominant global macro themes in 2010 along with fiscal and global imbalances. The last weekly letter dealt with US fiscal deficits and next weekly letter will address the global imbalances between the US and the rest of the world. I’m of the opinion that the monetary stance will be gradually moving toward neutrality in 2010 and to an even keel position in 2011. Investors should watch what might happen to quantitative easing for that’s the 800 pound gorilla in the room. The FED, in our opinion, is likely to stick to it’s stated plan to end purchases of mortgages at the end of March and roll back emergency lending programs in February.

The FED will be saved by the private sector and China in that they will take up the burden of financing government budget deficits. Private savings will substantially increase over the next few years because of the ongoing de-leveraging process of households, financial institutions, commercial real estate and non-financial corporations. The private sector could buy as much as $1000 billion of US treasuries in 2010.

The monetary authorities in China abruptly reversed course last Tuesday in a clear sign that they have turned their attention to controlling the repercussions on of a credit explosion by raising reserve requirements on banks and yields on short term bills. The money supply in China is up 35% on a year to year basis. These changes mark stage one and the turning point of China’s exit from emergency policies. Because China, for all intents and purposes, is under a fixed exchange rate in that its currency is linked to the US dollar; a tighter monetary stance should lead to upward pressure on the Yuan and, therefore, lead to more accumulation of international reserves in the form of US Greenbacks. China and other foreign countries may buy as much as $500 billion worth of US treasuries in 2010.

What these two sources of financing means is that the FED will be able to follow a monetary stance that will be more in tune with what it ought to be. The US economy may have ended 2009 with a bang, but the anticipated change in the fiscal and monetary stance means that the 2010 outlook will be mute for a post recovery year.

Hubert Marleau, Chief Investment Officer

Palos Management Inc.

 

BUY LOW-SELL HIGH: Emerging Markets Appear Fully Priced

Short history chart but nevertheless very telling and compelling from my standpoint.

Emerging market stocks are no longer cheap and already reflect a lot of good news, leaving them vulnerable to even minor disappointments.
Emerging market (EM) equity multiples have moved significantly higher in recent months, based on various valuation measures. A further multiple expansion in the developing markets would represent an overshoot of valuations from fundamentals. Indeed, there are two potential scenarios for EM stock prices: either a full-fledged mania will develop with multiples continuing to expand, or, a setback/period of indigestion will occur before a new upleg develops. Currently, the odds of a mania-type pattern developing in emerging markets are not significant. If a mania were to develop, Chinese stocks would be at the epicenter because China has the fastest growth rate. However, Chinese share prices (both domestic and investible stocks) have been trending sideways since July, and the investible market has underperformed the emerging market benchmark. Bottom line: At current valuations, EM stocks will be increasingly vulnerable to even minor negative surprises. Stay tuned.

BCA Research

 

Getting a Fair Share from ETFs

Read the fine print. ETFs are not created equal. Fund management companies neither. Some are friendlier to investors than others.

(…)Take the different performances of two ETFs invested in similar financial-sector stocks. The iShares Dow Jones U.S. Financial ETF saw its net-asset value fall 21.06% in the year through September 2009, underperforming the index it tracks by 0.01 percentage point after fees. Over the same period, the Financial Select Sector SPDR Fund lost 23.21%, beating its particular benchmark by 0.26 percentage point.

[ETFHEARD]

How? Part of the reason is that the iShares fund charges 0.48% in annual fees, while the SPDR fund charges 0.21%. Even so, for the latter to actually outperform its benchmark, it needed a boost.

The extra source likely was loaning stock to short sellers, who in turn give the lenders cash collateral that generates interest income. (…)

In total, the Financial Select Sector SPDR collected $21 million in stock-lending fees in the year through September. Some $3.1 million of that went to State Street, its partner. But $17.8 million was paid to investors, more than offsetting the ETF’s $13.8 million in expenses. Investors were effectively paid a fee to hold the ETF.

iShares isn’t so generous. In the year through September, the manager kept 50% of stock-lending fees, leaving just half of the total for investors. At the other end of the spectrum, Vanguard Group gives 99.5% of any stock-lending fees earned back to investors. Vanguard Financials ETF has an annual expense ratio of 0.25% and beat its benchmark by 0.29 percentage point in the year through September.(…)

The numbers might sound small. But compounded over many years they can make a real difference to performance. Investors should scan the small print for funds with the lowest fees and a generous share of stock-lending revenue.

Full WSJ article

 

INVESTING IN SWISS COMPANIES: BEWARE!

Novartis is taking control of Alcon paying Nestlé $180/share for its 52% stake.

But far from being on the receiving end of the same rich offer, Alcon’s minority shareholders are being offered just $153 in stock. There is little they can do. Alcon is incorporated in Switzerland, like Novartis, so Swiss merger law applies. And that gives little protection to minority holders.

They can’t reject the bid if they don’t like it. Instead, the price only has to be "equitable" to shareholders in the two companies agreeing on the deal, in this case Novartis and Alcon. It needs approval by a simple majority of each company’s directors and two-thirds of shareholders. These will be formalities given Novartis will own 77%, including the Nestlé stake.

Full WSJ article

 

PIMCO’s Cyclical 2010 Outlook

Here is asset allocation in action. PIMCO has cut risk exposure because it fails to see a clear path to the economy in 2010.

  • The global economic recovery underway will likely be very much de-synchronized, borne of heterogeneous initial conditions on display prior to the recession, with a full range of possible outcomes.
  • (…) there is still uncertainty over three major issues, which in turn creates a range of possible outcomes in our forecast. (…)

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    • The first issue is the peg between the Chinese yuan and the U.S. dollar, which essentially gives us a one-size-fits-all monetary policy in a very differentiated world. (…) If China were to let its currency appreciate, it could regain a degree of monetary policy autonomy and a better ability to manage the risk of overheating and asset price inflation. Another outcome, however, is that China refuses to let the yuan appreciate, essentially maintaining too easy of a monetary policy for itself and the developing countries that shadow Chinese policies. This would create bubble risk, particularly for assets such as emerging market (EM) equities and commodities.
    • The second major uncertainty is what will happen when the Fed completes its mortgage-backed securities (MBS) buying programs. We know that it will have an unfriendly effect on the interest rate markets, but we don’t know the magnitude, because it’s too hard to isolate the supply and demand dynamics between fundamentals and the stimulus programs.(…)
    • The third uncertainty is any change in the Fed’s pre-commitment language, which is currently committed to keeping the fed funds rate exceptionally low for an “extended period.” We don’t think the Fed is going to tighten any time in 2010, but long before the FOMC (Federal Open Market Committee) actually does the deed, it will have to change its language. That could very well happen in 2010, and there is genuine uncertainty over how quickly and strongly the market will anticipate a tightening process. Our gut feeling is that the moment the Fed changes any one of its words, it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination.(…)
  • We don’t think the U.S. is going to get a new stimulus package, but there will be a hodgepodge of things that fit the description. In fact, that’s one of the reasons that the Treasury has been pushing so hard for the banks to pay back Troubled Asset Relief Program (TARP) money, because the president plans to ask to Congress to move TARP money into Cash for Caulkers and other job stimulus measures. So we will get fiscal stimulus, but it will not be as big or explicit as what we’ve had so far.
  • The big unknown gets back to what we’ve already discussed: We’re probably going to have a $1.4 trillion deficit this year without the Fed on the buy side of the market for duration. There is major uncertainty about how the supply/demand equation for duration will resolve itself when the Fed is out of the picture.(…)
  • That said, we do have forecast numbers that generally capture the spirit of our discussions: sturdy growth in the emerging markets space, even if less than the Old Normal, and slower growth in the developed countries. Inflation, meanwhile, will probably be too low in the developed world because of still-huge output gaps. What the forecasts can’t tell, however, is that asset price inflation – including commodities – is becoming a more important dimension in our forecast because it’s becoming a more influential component of central banks’ reactions around the world.
  • The real story here will be told not in the GDP numbers, which are being driven by the inventory cycle, but by real final sales, which will continue to face the headwind of balance sheet deleveraging in the household sector. This is a critical tenet of the New Normal. Consumers can’t and/or won’t augment personal income by borrowing, so consumption must grow in line with personal income. Consumption isn’t likely to get a boost from the increase in stock market wealth because home values – a larger part of individual wealth – are still depressed. Thus, savings rates may stabilize at 4% or 5%, but may go as high as 8%.
  • As we translate all of this into investment strategy, we have to be incredibly cognizant of lingering uncertainties and the full range of potential outcomes. Because that range is so wide right now, our risk-taking is more tame than it would be if we had a normal distribution of expected outcomes. (…)
  • This all leaves us with portfolios that appear, more than at other times, to be hugging the benchmarks with no bold positioning.(…) we’re making a very active decision to run light on risk.
  • For interest rate exposure, or duration, we are currently cutting back in the U.S. and U.K. because, as mentioned before, supply and demand dynamics are likely to be negatively affected as borrowing rises and central bank buying declines. On the other hand, we remain modestly bullish on duration in the Eurozone, which has been congenitally disinclined to be aggressively Keynesian and won’t face the same degree of reduction in central bank duration buying in 2010. Regarding curve duration, we continue to remain modestly overweight.
  • With corporate bonds, we are becoming a bit more cautious than we have been. (…) Now, we’re generally neutral versus the benchmark, but we believe that corporate spreads are still at levels where we see value in carefully selected high-quality credits, particularly in bank and non-bank financials and non-cyclical sectors, such as utilities and healthcare.
  • In high yield corporate, we are adding very select names in telecoms and energy pipelines that we view as “money good.” In agency MBS, we are underweight, having reduced our exposure as the Fed’s buying programs have dramatically tightened spreads.
  • Our overall currency target is to be about 3% long a basket of emerging market currencies, generally against the benchmark portfolio currency. Similarly, we’re favoring emerging market sovereign credits, and the Dubai panic gave us additional legroom to enter into these trades. We are also adding to positions in EM corporate bonds.
  • Though we view Treasury Inflation-Protected Securities (TIPS) as a strategic long-term allocation, on a tactical basis we are underweight TIPS versus the benchmark, reflecting our view that risks are currently weighted toward a disinflationary environment. (…)
 

NATURAL GAS ETF (UNG): HEADS I WIN, TAILS YOU LOSE

While the shortcomings of ETFs that track commodities have been well documented, the discrepancy between the price of natural gas and the ETF that is meant to track its price provides a great reminder of why many of these more exotic vehicles should be avoided.  As always, investors should know what they own and look into these vehicles before investing in them.

The chart below compares the YTD performance of the front month natural gas futures contract and the United States Natural Gas Fund (UNG).  Through the end of August, natural gas and UNG were both down similar amounts and had tracked each other relatively closely.  Since then, however, natural gas has made a major reversal and is actually up on the year.  UNG, on the other hand, remains down over 55%.  In essence, UNG holders have missed out on the entire rally.

While the explosion in popularity of ETFs has had many positive effects and created numerous efficiencies for investors, the boom in the industry hasn’t been void of some individual busts.

Natural Gas ETF

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