Aditya's Blog

Hi!,

Jeremy Grantham’s latest quarterly is (yet again) a masterpiece, in particular the second part which is an edited version of his speech to students at Columbia University on asset bubbles. His firm GMO commenced a study of bubbles in 1998 and have, so far, identified 320 completed bubbles of a primary, secondary and tertiary nature (and 34 major bubbles which is likely to become 35 if the S&P reaches 1500!). They plan to write more on topic over the coming months. I summarise the letter below:

Current markets:

-As he had anticipated, the Year 3 of the Presidential Cycle phenomenon has worked out rather well so far with the S&P up 13% and the Russell 2000 (which includes small caps) up 19% since October 1. This has already brought the market close to the average Year 3 rise of 23%, spiced-up further by the addition of QE2 to the usual Year 3 stimulus.

-The possibility remains that the S&P drives up to the 1500 range by October 2011, which would make it officially in the list of true bubbles – and all of the famous bubbles eventually broke but usually after a rise in short term rates .

-He still sees the developed world having lower than normal growth rates and expects “seven lean years” in terms of asset returns. The main risks continue to be: 1) loss of wealth from housing, commercial real estate and , to some extent, stocks, which has lead to a large amount of stranded debt,;2) the slowing growth rate of the working-age population; and 3) increasing commodity prices.

-Quality stocks have continued to underperform small caps and lower quality stocks, and this may continue for a few more quarters as is typical in Year 3. However, while value may be a weak force in any given year, its force (like gravity) increases dramatically over years.

-The very famous and large bubbles also provide another warning - in the late stages of a bubble investors migrate to safer stocks and small caps underperform.

-The recent pattern of weather extremes is what has been predicted by scientists, and weather instability will continue to be the most striking side effect of global warming leading to shortages of resources.

-Commodities seem to be making a paradigm shift in recent years, but to validate this is a matter of judgement as history does not provide useful guidance for paradigm shifts.

-So going forward , be prepared to see continued outperformance of risky assets – though we will be living on borrowed time as the fair value for the S&P remains at 910.

-Emerging markets are in the early phases of a huge bubble as he had forecasted 3 1/2 years ago - how long this continues is anybody’s guess but be cautious.

-Resource stocks are great investments in the very long term, but vulnerable to short-term serious setbacks as they have run up a lot recently,

-Forestry and good agricultural land continue to be safe long-term investments.

Asset Bubbles:

-The only thing which really matters in investing are bubbles and the busts.

-Career risk continues to drive the institutional investment world – and Keynes described it perfectly as never being wrong on your own but being wrong in company is fine.

-Momentum or trend following is the single biggest inefficiency in the market and Keynes (yet again) had something useful to say on the subject by noting that extrapolation is a “convention” we adopt to deal with an uncertain world even though we know, from experience, that it doesn’t usually work.

-The market is only efficient when it crosses fair value briefly (every 5-7 years?) but rest of the time its spiking up or down and is inefficient.

-One of the great oddities of the market is that high profit margins are associated with high p/e multiples- which is contrary to what you would expect under capitalism –i.e. high profit margins attracting more competition and driving down returns. This correlation make sense for individual companies but for a market as a whole, where profit margins are mean reverting, it makes no sense.

-This double counting is the greatest driver of market volatility and when combined with career risk, herding momentum, extrapolation and a generous supply of money – almost certainly leads to a bubble.

-Forecasting bubbles is tough work and involves substantial career risk. However, the task of forecasting the breaking of bubbles is easier as their breaking is certain or very nearly certain.

-On average, bubbles go up in three and a half years and down in three. All bubbles eventually burst and go back to their trend line which was in place before the bubble started.

-The story about Isaac Newton’s involvement in the great South Sea Bubble is telling – he got in very early and sold early making a decent profit, but then suffered the most painful experience in the investing world: he watched his friends get really rich- so he got in again at near the top (with borrowed money!) and finally had to exit broke.

-The recent US stock market bubble which started bursting in 2000 , did not get all the way down to the trend line as Alan Greenspan’s aggressive easing postponed the inevitable and created, the “largest sucker rally in history” from 2004-2007, to be followed by the great bust which finally did bring it back to the trend line (but not, yet, below it as history would point towards!).

-Responding to the ebbs and flows of cycles, and making big bets at extremes, is easily the best way to add value to your portfolio and reduce risk. The great bubbles will wash away even the best Graham and Dodd stock-picking portfolios.

Marvellous insights and I am looking forward to more pieces on bubbles as I fully agree that the time to make the big bets is at market extremes, while rest of the time one should tinker with the portfolio and try to stay out of trouble! What is fascinating, is that while bubbles are easy to identify to an objective observer, it is impossible to convince the “locals/insiders/experts” who tend to be fully immersed in the story and therefore cannot separate the weeds from the trees! Some examples from my direct experience –the Japan stock market and real estate bubbles in 1990 , and the current China, Hong Kong, Singapore and Indian real estate bubbles. Yes, the arguments in favour are always very convincing and special to the particular situation, which may prolong the bubble for a while, but the way to identify it clearly is to draw a trend line and see if the current market price is 2 standard deviations above it! For real estate, the trend line can be growth in income or rents, and the market should be an average multiple over it, an exponential rise above that is a bubble! While we are on bubbles, most investors spend most of their time on making buying decisions, but equally (if not more important), are the sell decisions! Remember what the great investor Bernard Baruch said on being asked the secret of his success – “I always sold early”!

So what does one do in the current environment - as I have noted in previous emails, steadily accumulate stock funds/etfs/indices in select EM markets (mainly Greater China, selectively in India, Russia, Brazil) primarily as a hedge against inflation (as I believe EM countries will ultimately opt for growth at the cost of inflation) , in the US (high quality, resources and materials), select credit funds for income (Pimco has some good closed-end credit and municipal bond funds) and maintain core weightings in US government bond portfolios as the recent sell-off is way overdone (though we can expect more volatility particularly if core inflation temporarily moves higher over the next few months)-see note on inflation below.

On Inflation (from Paul Krugman):

The point here is that there’s an important distinction between the prices of wheat, oil, rubber, etc. that may rise or fall by double-digit amounts over the course of a year, then quickly reverse that rise or fall, and the prices of many services and manufactured goods — and most wages — which are set for periods of months or years. The latter are slow to develop inflation, but also slow to give it up, which is why policy should focus on whether those prices have started to rise too fast (or too slowly).

The question, however, is whether changes in the flexible-price goods feed into persistent inflation in the core. if we think of wages as the ultimate core price, I don’t see any mechanism in today’s America whereby rising commodity prices translate into higher wage contracts. But what does the historical record say? It depends on which era you’re looking at.

From the Atlanta Fed data:

The two big commodity price shocks of the 70s did, in fact, feed quickly into core inflation. Since then, however, they had no impact. Why the difference? The obvious point is that back in the 70s many labor contracts included cost of living adjustments (COLAs). This in turn partly reflected stronger worker bargaining positions and also real doubts about whether monetary policy would contain inflation. Today, none of that: COLAs are rare, and commodity-price fluctuations don’t feed into wages at all.