Risk Latte - On Grantham and Dow trend lines

On Grantham and Dow trend lines

Aditya Rana
November 7, 2010

Yet another masterful quarterly note from Jeremy Grantham of GMO – if you have the time to read only one investment letter i would suggest Grantham’s quarterly as you are likely to get more out of it than most other writings on financial markets put together – and it costs nothing! It is a long piece and I have summarised below relevant sections, but the whole letter is well worth the time taken.


  • Analysis of long-term data shows that lowering interest rates to encourage more debt does do not lead to higher GDP growth rates over the long run – US debt tripled over the last 28 years but the growth rate dipped from 3.4% to 2.4% per annum.


  • However, artificially lower rates do lead to speculative markets. For example, Year 3 of the US presidential cycle are associated with easy monetary policies leading to highly speculative markets with an extra above average market rise of 18.5%.


  • The economic impact of higher asset prices, via the wealth effect, is only felt the following year with an extra above average GDP rise of 0.6%. This holds true during year 3 of presidential cycles as well as other periods involving significant market moves on the upside.


  • This impact is felt globally, with other markets having an even higher extra rise compared to the average - “Never fight the Fed about market prices or underestimate its global reach”.


  • The impact of higher stock prices on the economy is relatively mild while the impact of higher housing prices is more significant, particularly if they are followed by a surge in home building and related employment.


  • Housing bubbles are more dangerous as they are more widely owned, more easily borrowed against (with no margin calls) and viewed to be more stable – thereby having a bigger wealth effect both on the upside as well as on the downside.


  • Artificially engineered higher asset prices cause various distortions to the normal functioning of the market – in particular, marginal and highly leveraged companies are favoured compared to conservative blue chips. Additionally; pension funds, endowments and local government make unrealistic assumptions on revenues and investment returns which eventually contributes to exacerbating the crisis.


  • Lower rates always transfer wealth from retirees to corporations and the financial industry – however, in the current environment there are more retirees (i.e. lower consumption) and corporations lack investment opportunities thereby providing no net benefit to the economy as a whole and possibly even holding back a recovery.


  • The stimulus provided by lower interest rates and higher asset prices is eventually given back (with interest) when eventually the bubbles overcorrect.


  • Quantitative easing is a last desperate manoeuvre without regard to future costs, and by unilaterally weakening the dollar it significantly increases the risks of currency friction which could spiral out of control.


  • A policy of low rates, quantitative easing , stimulating asset prices ignoring the consequences of bubbles breaking and refusing to learn from experience has made a manipulative Fed policy a strong negative to the long term health of the economy.


  • Further fiscal stimulus is required – carefully targeted at infrastructure and improvements in energy efficiency which will lead to higher societal returns and, importantly, provide employment.


Investment implications:


  • The S&P is likely to reach levels of 1400 to 1500 a year from now (though significant risks remain and dips should be used as buying opportunities), which would make it badly overpriced and given current expectations of seven lean years it would make the prospects for the following 6 years quite unpleasant.


  • Quality US stocks remain relatively cheap and finally seem to be getting the recognition they deserve. Over the next year the odds of quality stocks outperforming versus small cap/lower quality stocks should increase significantly.


  • Emerging markets are fully priced with “everyone and his dog” now overweight emerging markets. However, they still sell at a 75% discount to the S&P which are not quality stocks and are eventually likely to sell at a premium given their much higher GDP growth rate which provides a powerful impression of value.


  • Commodities have overrun and resource stocks should be bought only on a major price decline. Over a long horizon (20 years) resources in the ground like agricultural land and forestry provide would make sense.


  • Gold is not of much value over the long-term and resources in the ground, forestry, agriculture, common stocks and even real estate will provide a better hedge against inflation and a currency crisis than gold.


  • Carry extra cash reserves, as an option value to take advantage of drops in stocks (which are overpriced), bonds (which are even more overpriced) and commodities.


  • UK and Australian housing continue to be the two bubbles in 34 which have not corrected – and pointing out housing bubbles continues to be very upsetting to people! These two housing bubbles were different from the US housing bubble as they did not have big increases in construction. However, financing costs account for a very high share of income in Australia making it unsustainable and artificially low floating rate mortgage rates in the UK make the market susceptible to eventual rate increases.


Jeremy Grantham covers a lot of ground in this newsletter and in a characteristically analytical and enlightening manner! And what is absolutely amazing is his track record in calling the market at important turns - whether it was the Japanese bubble, the tech bubble, the US housing bubble, the March 2009 bottom, and the start of an emerging market bubble! His expectations of a further 20% odd rise in the markets are probably spot on as well in light of the “risk on” trade being back in favour. However, it is important to note (as he points out) that any excess speculative returns over the next year or so are only front loading returns from what is still expected to be a lean period for most of this decade. Therefore, the higher the market rises in the medium term, the more cautious one needs to be regarding subsequent long-term returns (easy to say but extremely difficult to follow!).


To illustrate the above point, I have attached two interesting long term charts of the Dow (from The Charts Store via Big Picture) which chart the Dow versus its long term trend line growth rate of about 5% per annum. Currently the Dow is 65% above its trend line (and the March 2009 low was still 10% above the trend line!) and likely to increase further as noted above. However, it will be unprecedented to have this secular bear market (which started in 2000) to end without the Dow falling back below its long term trend line. My expected time frame for that event to occur – during the 2014 to 2016 period-so enjoy the ride in the interim!


As i have stated in previous newsletters, i expect to cautiously (and steadily) commence buying stocks/funds for the first time in 3 years in December (after the euphoria over QE2 settles somewhat and the G-20 meeting on global imbalances is cleared) with a primary focus on US high quality and infrastructure. I continue to believe the US will lead this cyclical rally, with some relatively underperforming and undervalued emerging markets (Soc Gen had a note out recently which points out that out of the BRIC countries, China and Brazil trade at a cyclically adjusted PE of 16, Russia is at 10 while India is at an expensive 25).




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