On Bubbles & Crashes, Inflationary trends and BRIC valuations
November 14, 2010
We live in unusual times, with the unprecedented involvement of governments and their agencies in financial markets making the task of predicting outcomes in response to policy actions even more difficult than is normally the case. In the old days, if one bought stock markets during Fed easing cycles and sold them during Fed tightening cycles one would have, more often than not, done quite well. In the current environment, the aftermath of QE2 has provoked a heated debate amongst thoughtful market participants about the future course of the markets and the economy. Last week I summarised Jeremy Grantham’s quarterly note which was highly critical of Fed actions but also acknowledged that QE2 is likely to take markets from overvalued levels to bubble territory over the next year or two. This week i summarise the arguments made by the perspicacious fund manager John Hussman about the Fed actions and their likely consequences:
- Bernanke’s statement that QE2 is likely to support economic expansion by creating wealth effects via the increase in stock prices are ” undoubtedly among the most ignorant remarks ever made by a central banker”.
- Historically, the benefit of a 10% move up in the stock market results in less than a 0.5% rise in GDP over a two year period, as investors view the wealth effect as impermanent.
- Artificially boosting up stock prices changes the distribution of long-term investment returns but does not affect the returns themselves – i.e. it frontloads the returns.
- What QE2 achieves is changing the mix of government liabilities in the economy (monetary policy) but does not alter the total quantity of the liabilities (fiscal policy) and therefore does not have a material impact on inflation or employment.
- The primary reason that QE1 was somewhat effective, had nothing to do with monetary policy, but was due to its backdoor fiscal effect achieved by guaranteeing debts of Freddie Mac and Fannie Mae (which amounted to a subsidy).
- Bernanke continues to confuse monetary policy and fiscal policy in his writings –using money creation to buy goods and services is fiscal policy and using money to buy other government liabilities in monetary policy.
- With the low level of dividend yields, the duration of the S&P 500 is over 50 years making it very sensitive to a back-up in dividend yields which is likely as they are currently at half the historical norm.
- Correlations between asset classes have moved up from a normal 30%-40% to 80%, as government interventions are supporting all assets. However, speculative companies have significantly outperformed quality companies and therefore would be more vulnerable to a market decline.
- 30-year US Treasury yields have risen to 6-month highs and rising yields against the backdrop of an overvalued, over bullish and overbought market, typically results in a steep correction or a new bear market within a short period of time.
- Projected total returns for S&P 500 over the coming decade are 4.5%, wit 3-5 year returns expected to be zero with a high degree of volatility around zero. The market is highly speculative at the moment.
Hussman makes (as usual) very insightful and valid points and is in sync with Grantham by expecting low return from the stock market over the rest of this decade. He is justly critical of Fed policies which rely on replacing one bubble with another in the false hope of raising consumer demand on a permanent basis. His observation about the differences between monetary and fiscal policy is astute and sheds light on the often confusing debate in the media about the inflationary impact of QE2 – by replacing treasury bonds in the hands of the public with cash and bank reserves, the impact is only inflationary if it results in an increase in credit and spending for goods and services in the economy. In contrast, fiscal policy directly increases the purchases of goods and services, and is inflationary if implemented in an economy with already sufficient level of aggregate demand (which is not the case currently). So with the current levels of deficient demand and excess capacity in the economy, the current trend of declining inflation (with core inflation at about 1%) is likely to continue for a few more years, even if there is some recovery in GDP in 2001 (see attached graph via Paul Krugman).
Therefore, 30 year US Treasuries with yields at 4.24% provide an attractive return profile over a 6-month horizon, once the inflationary concerns abate. This can be implemented by buying the ETF TLT (long dated treasuries) or the ETF ZROZ (long dated zero coupon treasuries). Lastly, the US dollar presents good value versus currencies like the Euro – both from a fundamental perspective with a QE programme typically resulting in an initial sharp sell-off of the currency followed by steady appreciation (please see Hussman’s note on this subject written on August 23, 2010 on their website
www.hussmanfunds.com), as well as a technical perspective given the over bearish sentiment towards the dollar (only 3% bulls).
As I mentioned in last week’s blog I expect to commence buying equity funds sometime in December in select, and relatively undervalued asset classes, like US high quality, and emerging markets like China, Brazil and Russia. As Jeremy Grantham has noted, US high quality has underperformed and GMO expects the asset class to provide seven year nominal returns of 8.2% per annum versus US large cap returns of 4.2% pa and US small cap returns of 2.3% pa. Emerging markets are expected to return 7.6% pa, with variances between different countries. I attach below 7 year cyclically adjusted real P/E ratios for the BRIC countries (from Dylan Grice of Soc Gen) which clearly illustrate the overvaluation of the Indian stock market and the relative value in countries like China, Brazil and Russia. So as both Hussman and Grantham have pointed out, buying relatively undervalued asset classes will provide more potential upside, as well as better protection in a market decline than the more overvalued markets. However, given the high degree of uncertainty surrounding the markets, the economy and government actions, I would describe myself as a paranoid long and will be looking to exit as we move from overvalued to bubble territory (around the 1500 level for the S&P 500 compared to fair value of about 950).
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