Saturday, January 30, 2010

Fundamental Valuations and Forecasts

GMO's 7-Year Forecast by Asset Class

Jeremy Grantham of GMO has long been one of my favorite asset managers and financial commentators because of his value-based approach, his long-term investment horizon, and his warnings about fads, national debt, and growing asset bubbles.  The GMO January Letter is interesting for its 7-year forecast of annualized returns by asset class.

Seven Lean Years

The forecast begins with the prospect that a continuing Fed policy of low interest rates will promote another speculative asset bubble, again endangering the economy and the financial system.  This bubble may boost stock prices in the near term but the bubble will eventually burst.

Grantham believes that the economy faces what he calls "Seven Lean Years", because "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 ..."

The US stock market is already overpriced, but it may continue advancing and become even more overpriced, Grantham believes.  He estimates that the Standard and Poors 500 index is worth only about 850 but becuse of Fed policy may go to around 1200 before declining.

Expected Returns by Asset Class 

He considers the "high quality" component of the US stock market to be "relatively cheap", however.  I don't know GMO's criteria for high quality, but investment strategists commonly use criteria such as a good balance sheet, cash flow, decent current valuation, and good business prospects, as is the case as with a subset of US consumer staples companies.  Except for managed timber, other assets are overpriced relative to history -- international equities a little so, fixed income very much, and cash extremely so.  I've included GMO's chart of forecast annualized 7-year real returns by asset class.

Note that the chart includes no other commodities than managed timber, nor any other real estate.  GMO's long run inflation assumption is 2.5% per year.  International equities are ex-Japan.  Note also that there is a wide band of uncertainty around the central estimates.

In case the chart above is not legible, here are the 7-Year Asset Class Return Forecasts: US equities: large cap 1.3%, small cap 0.5%, high quality 6.8%. International equities: large cap 4.7%, small cap 4.6%, emerging 3.9%. Bonds: US government 1.1%, international government 1.3%, emerging 2.1%, inflation indexed 0.8%, US Treasuries (30 days to 2 years) -0.6%. Managed timber 6.0%.

Risks in This Environment

The most salient feature of this chart for investment strategies is that expected returns are much lower overall than historical averages.  In this environment, GMO feels that professional managers, being more concerned with comparison to their peers than with absolute returns, will be "seduced into buying equities because cash is so painful."  The problem with that approach is that "Equity markets almost always peak when rates are low,so moving in desperation away from low rates into substantially overpriced equities always ends badly."

GMO Investment Strategy

GMO's solution to this dilemma, Grantham says, is to only slightly underweight international equities, but "tilted to quality", because the EAFE index is priced not far below historical norms.  The rest of their portfolio is in fixed income, despite the meager expected return, although they do not specify the composition within fixed income.  The equity allocation will be slowly reduced, however, if the equity markets continue to advance.

PIMCO's Ring of Fire

In contrast to GMO's expectations for asset classes, Bill Gross's recent PIMCO commentary discusses investment prospects across countries. As explained in "The Ring of Fire", Gross's approach seems to be based in part on fundamental valuation methods, as GMO's is, although he uses a different set of metrics more suited to fixed income.

Gross finds similarities between PIMCO's New Normal and a book that I have written of in earlier commentaries -- a study of eight centuries of financial crisis titled This Time Is Different by Carmen Reinhart and Kenneth Rogoff.  PIMCO's thesis is that financial crises are followed by a process of deleveraging (shifting debt from the private to the public sector) which reduces economic growth and lowers returns on investment for a protracted period.  PIMCO categorizes countries as red, yellow, or green based on public sector debt and the public sector budget deficit, both as percentages of GDP.

In PIMCO’s chart “The Ring of Fire”, the most vulnerable countries are shown in red.  "These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth."

PIMCO Investment Strategy

The conclusion that Gross draws is the difference "between emerging and developed economic growth, forecasting a much better future for the former as opposed to the latter."  His investment strategy divides assets into growth, emerging markets fixed income, and developed markets fixed income:
  1. Growth assets (as well as currencies) should be allocated to developing countries that are less levered and less prone to asset bubbles. "Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples."
  2. Fixed income assets should be allocated to emerging countries when the opportunity occurs. However, reduced liquidity and less developed financial markets (e.g., property rights) make the emerging economies less appealing for fixed income, which means that "most bond money must still look to the “old” as opposed to the new world for returns."
  3. Most fixed income assets should be allocated to a carefully selected subset of the developed nations, but the large, traditional bond markets should be avoided -- Japan because of demographics and the need for external financing, the US because of deficits and entitlements, Europe because of  the debts of nations on the southern tier, and the UK because of its high debt.  His top preference is Canada because of its fiscal balance and conservative banks, which did not participate in the housing crisis.  His second choice is Germany "the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched".
This is a much different strategy than GMO's, which does not give so much weight to emerging market equity and allocates to fixed income only grudgingly, but it is useful to see the investment world sliced and diced in different directions.

Woodcuts by Gustave Baumann (1881-1971), known for his work in Santa Fe, New Mexico and his depictions of the southwest

Friday, January 29, 2010

Back in Michigan

Here I am, emerging from a kiva in the ruins of a pueblo at Pecos National Historical Park, New Mexico.  As you can see, I am leaving no source unexamined in the quest to understand the repricing of global financial assets.  More on the topic of asset valuation later, as I re-acclimate to the Michigan winter.

Sunday, January 24, 2010

The Fate of Debtors

Late last year I wrote a commentary titled "Eight Centuries of Financial Crises" about the book This Time Is Different—Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff. I felt that this book would be of particular value to today’s investors because it analyzes the differences and similarities of over 250 financial crises in 66 countries over the past eight centuries. Today I would like to discuss lessons that other observers have drawn from that book and the application of those lessons to the current financial crisis. The findings are especially timely as the Fed appears headed toward an exit from quantitative easing, and as the US, Japan and Europe face the prospect of funding extremely heavy debt loads in the coming year.


These thoughts appeared in The Big Picture blog, in the weekly commentary of John Mauldin titled "Thoughts on the End Game". The majority of the post reproduced the fourth quarter 2009 review and outlook written by of two of Mauldin’s colleagues, Van Hoisington and Dr. Lacy Hunt.

Based on the book This Time Is Different, all of these commentators conclude that the outcome of the present process of deleveraging will be an era of deflation, continued low interest rates, and outperformance of US Treasury securities compared to alternative investments. Now, this is not a point of view that I necessarily subscribe to, but we should take a look at the evidence and the arguments.

Five Lessons

Hoisington and Hunt abstracted five lessons from This Time Is Different concerning today’s financial predicament. I’ve quote these five lessons in bold and added my own comments:

First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.

Ever since the 1970s, I’ve heard politicians justify their pet programs and dismiss complaints of rising Federal debt, saying that critics “don’t understand” how government finance works. After all, they said, “we owe the debt to ourselves” and it all balances out in the end. What liars! Domestic debt does matter, no matter who the creditor is. If you are crushed by debt, you cannot obtain the credit needed to grow your business or support your family. You have to cut spending and pay down your debts, even if you don’t enjoy your reduced standard of living. Unfortunately, our collective debts are getting more unsupportable. That’s where we are now as a nation.

Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.

So, politicians were lying when they said that it didn’t matter that we owe our debts to ourselves. Domestic debt does matter, and the size of the debt is the critical parameter.

Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, “Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Rather than “reigniting” the economy, government stimulus will have only temporary effects. The underlying debts will remain and they will continue to act as a drag on the economy. The “green shoots” will wither once stimulus runs out, and we will face years of high unemployment, constrained spending, and recessionary economic conditions.

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

It isn’t different this time. Debt crisis ends badly.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

Systemic risk is what precipitated this crisis. It is totally self-defeating to try to kick start economic activity by prompting banks to lend and consumers to borrow, because high debt levels brought down the system in the first place. The Federal government is only exacerbating the problem by running up astronomical debts trying to solve the crisis, and placing our financial system at even greater risk. Low interest rates help people finance their debt loads and speculate in the financial markets, but low interest rates will end someday, at a time when the bubble is even larger.

The Deflationary Outcome

There is much widespread debate today as to whether the current crisis will end up in inflation or deflation. In their book, Reinhart and Rogoff presented evidence that major debt crises have deflationary outcomes. In their quarterly commentary, Hoisington and Hunt extrapolated to conclude that interest rates will remain low for an extended period and say: “We are buyers and holders of long term U.S. Treasury debt.”


This is a sobering conclusion, but we must be cautious when interpreting historical cases. There are still important questions to answer, of which only a few are: Wouldn’t outcomes be different when countries lacked a well developed domestic credit system, such as banks and bond markets? Doesn’t a transition to fractional reserve banking confer enough flexibility to make a difference? What about the introduction of central banks? What about the effects of markets for securitized mortgages, consumer credit, accounts receivable, and credit default risk?

For example, colonial Spain defaulted on its debts numerous times, but that was when Spain depended for financing on marketing its plentiful supply of New World silver rather than a domestic system of commercial credit, as was developing in other parts of west Europe. Germany had budget problems after the Great War but didn’t experience hyperinflation until the victors forced the payment of reparations and limited the country’s options to printing the money.

The overall pattern of crises may appear similar over a long period of history, yet occurrences and outcomes may differ in essential details that matter critically. Details do matter, and we must exercise some caution in our interpretations. I can only advise reading the book, at a minimum. Fortunately, Reinhart and Rogoff go into more detail in This Time is Different than I can do justice to in this space.

As I said earlier, I don’t necessarily agree with all of this, but I also believe that historical precedents should be included in our deliberations when analyzing something as complex as the world financial and economic system.

Thursday, January 14, 2010

Between Scylla and Charybdis

A number of Wall Street investment banks are calling for a positive year in the US stock market, and many others are calling for a good first half of the year, followed by a weak second half, as the Fed cuts back on its easing. As suspect as Wall Street’s pronouncements may be (who would believe Goldman Sachs?), it must be admitted that the Fed’s accommodation is a very friendly environment for the markets, and a tighter stance would likely end the good times.

Although many commentators say that they are expecting a tighter Fed policy this year, when we look more closely, there is a variety of viewpoints about likelihood and timing. Let’s look at three opposed viewpoints : (1) a declining stock market due to Fed exit, which is the prevalent viewpoint, (2) a prolonged market advance because the Fed finds it impossible to exit, and (3) a new financial bubble in commodities (triggering another economic downturn) once it is understood that the Fed cannot exit.

A Fed Exit in 2010

Bill Gross of PIMCO is one of the most vocal and most visible proponents of the view that the Fed will cut back on quantitative easing this year. As described in his January 2010 commentary, Gross summarized his view this way:
If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.

If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.

… 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.
The reason that 2009 was so dominated by the government sector was the extraordinary amount of fiscal and monetary stimulus, including:

… the global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars … the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP.
The reason he believes that this stimulus must end in 2010 is that:
… the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.

Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.
Despite the Fed’s apparent plans, Gross thinks that the exit from quantitative easing will not be so graceful:

Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. … foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.
Although Gross doesn’t say so explicitly, the implication is that, in the absence of further Fed purchases, the market for Agency mortgages will be, to say the least, weak. Also, given that PIMCO and other funds have already loaded up on Treasuries, the US may face problems selling the new Treasury issuance that will be coming to market in 2010. Higher interest rates on mortgage securities and Treasuries would discourage investors, businesses, and consumers, providing strong headwinds against stock and bond markets and the economy.Putting this all together, Gross is predicting a “double whammy” resulting from (1) heavy debt loads in the “spendthrift” nations and (2) the withdrawal of government support from the financial markets:

Gross doesn’t see the Fed exit strategy as the only problem. Like others, he feels that budget deficits already incurred will be a drag on both the economy and the Treasury securities market for years to come. Interestingly, he quantified the impact:

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.

Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Putting this all together, Gross sees a "double whammy" of debt loads for many nations plus the end of easy fiscal and monetary policies:

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more.

… the shifting of private investment dollars to more fiscally responsible government bond markets … in 2010 and beyond.

Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.
I recommend looking at Gross’s commentary for the chart comparing the deficits and debt levels of a number of large economies. It is fascinating that PIMCO is quantifying the impact of the US budget deficit in terms of bond pricing relative to more prudent countries.

Also, it is interesting to compare Gross’s statements to those of another PIMCO executive, Mohammed El Erian. In Fortune’s 2010 investment guide, El Erian expressed great doubts about the US economy’s ability to sustain any kind of recovery this year. That’s hardly the right environment for Fed tightening, but maybe PIMCO thinks that the Fed has run out of ammunition.  Credit rating agencies have warned that the US must cut back spending or else risk a downgrade.

 No Fed Exit in 2010

The RGE Monitor, Nouriel Roubini’s website recently published an article that argued against any tightening during 2010. The core of their prediction was:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes …. We expect the Fed to stay on hold throughout 2010 ...
This is a complete turnabout for Roubini, since not long ago he was writing about the danger that accommodative monetary policies would fuel a continued carry trade on the US dollar and fuel dangerous bubbles in financial markets around the world.

Perhaps Roubini has a point about near zero rates. With unemployment running around 10%, will the Fed dare to tighten ahead of the November midterm elections? With fiscal stimulus running out in the second half of the year, monetary tightening may be out of the question.

In contrast to Roubini, Gross’s prediction is based on Fed and Administration expectations of a self-sustaining economy (do we believe that?) and the supposition that the Fed is being forced to clean up its own balance sheet.  Given the extent to which much of the world is dependent on the US economy, it hardly seems likely that anyone would encourage the Fed to tighten when the economy is at best fragile.  Thewarnings of Fitch et al. hardly matter compared to the stances taken by the central bankers of the world.

No Fed Exit and a Commodities Bubble

In "Roubini v. Gross on Outlook for 2010", Yves at the Naked Capitalist blog points out that if Roubini is correct and the Fed does not tighten in 2010, the markets will create their own organic problems. The reasoning is that continued accommodation will encourage risk-seeking trades (carry trade in the US dollar) that will push money into “hot” assets. In this view, the most dangerous recipient of these flows is commodities. As we saw during the last oil bubble, rising commodity prices produce a drag on the economy – a drag that 2010’s fragile economy can hardly afford.

Warnings about rising commodity prices are already appearing in the press, such as this recent article this recent article  in the Wall Street Journal, and a growing global asset price bubble is depicted on the latest cover of The Economist.  There is some justification for these warnings, because the valuation of the US stock market is approaching historical highs on fundamental measures, and a number of emerging stock and real estate markets are looking overheated.  As we have seen during the past decade, inflating bubbles can persist for a quite some time before they burst.

Negative feedback from a slowing economy would eventually burst the bubble – but damage would already have been done to both the economy and financial markets.

The Fundamental Problems Remain

I don’t know which, if any, of these views will turn out to be correct, but the Fed is in a dilemma. Despite massive quantitative easing last year, the underlying problems weren’t solved, they were only postponed. We still have heavy public and private debt loads, banks holding impaired financial assets, and unaffordable home prices. Remove the lax monetary and fiscal policies and the financial markets will dry up, credit will tighten, and the economy will suffer. Continue the laxity and money will flow where it can find a return, into bubbles, not into the basic US economy.

Whether the Fed tightens or not in 2010, the financial markets and the economy are still caught between the Scylla of crushing debt and the Charybdis of unbridled speculation.