Still dancing?

“Bubbles are the only things that matter. The rest of it is boring. You show up for work, markets are at normal levels, and there’s not much you can do. It’s all trivial. But in a great bubble you can get your clients’ arses out of the way, and the money you can save can be quite legendary.”

– Jeremy Grantham speaking to The Financial Times, 7th August 2015.

Doug Noland is surely right when he writes that

“There just can’t be a more fascinating endeavour in finance than analysing Credit and speculative Bubbles. Such undertakings do not come without challenges.”

The primary challenge is that while people like to think they are interested in preserving their capital over the long run, most of us are secretly won over by the prospect of making a fast buck in the here and now. The defining quote of the financial crisis was inadvertently made by the former boss of Citigroup, Chuck Prince, when with admirable if misplaced honesty he confessed, in 2007,

“When the music stops, in terms of liquidity, things will be complicated, but as long as the music’s playing, you’ve got to get up and dance. We’re still dancing.”

Never has the ‘institutional imperative’ been more succinctly encapsulated. Head up a bank, and for as long as the music’s playing, you are compelled to frolic. It may turn out that you are dancing on the edge of a volcano, but the ‘institutional imperative’ is a harsh mistress, and she takes no prisoners.

Honesty is often a tough commodity to come by in the world of asset management. The ‘institutional imperative’ puts a premium on assets under management. And assets under management pretty much requires telling people what they want to hear. People want to hear wealth creation, and they are not pleasantly disposed to commentaries on the scantiness of the Emperor’s new clothes. So it was fascinating last week to read the FT’s coverage of the latest musings by the founder of fund management group GMO, Jeremy Grantham, in his assessment of market opportunities, or the lack thereof. Depending on which issue you came across, the headline read either ‘GMO founder Grantham says markets ‘ripe for major decline’ in 2016’ or ‘Uber-bear Grantham survives the bull run’. What readers of the print edition will not have read is the reader interaction afforded by the FT’s website. The correspondent ‘Consider This..’ writes:

“What this article should have included is that investing has been perverted to closet gambling. The overwhelming type of information from the securities industry and the media is purposely designed to pander to humans’ short term desire for large unrealistic gains. Sell them what they want ! Their approach actually works very well until it stops and then investors look around stunned that nobody warned them, as if they would have heeded the advice ! As a professional in the business for about 30 years, I have found no-one better than Grantham in predicting future returns from the 10 asset classes he forecasts. This article struggles to give Grantham credit, couching his accomplishments with cheap disparagements about assets under management as if the amount of assets reflects investment performance or risk adjusted returns. Shameful reporting on that account !”

“Here’s the deal, the media.. cannot entertain you with the prospect of big short term gains by talking about boring subjects like full market cycle returns because it requires you to be patient and disciplined, characteristics humans struggle with. Finally, there are precious few portfolio managers who have good full market cycle performance. Grantham has excelled in this area as facts have shown. I do thank FT for the article on one of our industry’s great strategists and students.”

Much of the problem lies with the dichotomy between Finance World and the Real World. Tom Wolfe, citing the Austrian economist Joseph Schumpeter, once wrote:

“Stocks and bonds are what he called evaporated property. People completely lose touch of the underlying assets. It’s all paper – these esoteric devices. So it has become evaporated property squared. I call it evaporated property cubed.”

The author Satyajit Das would add,

“Extreme money is eviscerated reality – the monetary shadow of real things.”

Our friend Guy Fraser-Sampson has nicely described the situation. If human beings vanished from the earth tomorrow, the likes of economics, financial markets, and money – of any meaning – would vanish along with them, but the world would still turn. Finance is a demon of our own design, and the world we inhabit has arguably become acutely over-financialized.

The financial media now obsess over the likelihood, timing and degree of any rise in interest rates in the Anglo-Saxon economies. (Put to one side any doubts as to whether interest rates might be better set by free markets as opposed to a narrow banking cabal implicitly serving government interests.) What difference does it make ? Warren Buffett once wrote about the farmland he bought in Nebraska in 1986:

“With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

“Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)

“My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska..”

Nevertheless, and notwithstanding the above comments, we’d be surprised if either the Federal Reserve or the Bank of England raised rates any time soon. Whatever the domestic situation, the world economy is clearly slowing, as evinced by a dramatic sell-off in the prices of all commodities, worldwide. That makes equity market valuations in many developed economies, in our view, somewhat difficult to justify. That said, the growing deflationary impulse may yet provoke a fresh wave of monetary stimulus, taking the prices of financial assets even further away from their (unperverted) fair values.

We believe the rational conclusion is to steer away from objectively expensive assets and to sail towards bargains. Can inexpensive assets even exist in a world beset by QE and the growing  prospect of more of the same ? We think the answer is yes. Here is a recent commentary from one of our managers:

“We visit companies across [the country] and one cannot overstate the changed mentality of management towards focusing on, and improving, their company’s return on equity and shareholder returns; these two areas are now integral to most management’s medium term plans. This change in mentality is a result of several factors, including younger management teams who realise that protecting the status quo and seeking harmony will undermine their company’s long term competitiveness, and more pressure from domestic and foreign investors.

“We were pleased to recently add a couple of companies to the fund with very attractive metrics. These firms are in isolated locations and receive few visits from investors, yet are positioned to enjoy a strong earnings environment over the next three to five years.”

Whether you can potentially benefit from such fundamentally attractive valuations will depend on whether you, or your fund manager, are looking to the past, or to the future, and to what extent you are constrained by benchmarks (given that the objectively expensive US stock market accounts for nearly 60% of the MSCI World Equity Index, for example. The S&P 500 trades on a Shiller price / earnings ratio of over 26 times. Its long run average is under 17. Private equity selling of US stocks, a.k.a. “the smart money”, is also running at record levels. If “the smart money” is getting out, you might not want to  be getting in.) This tremendous ‘value’ opportunity cited in the paragraphs above, benefitting in addition from a sea change in corporate governance and attitudes towards shareholder returns driven by the government itself, is Japan. The West now faces the threat of outright deflation. But as Christopher Wood of CLSA points out,

“The best way of looking at the potential for improvement [in Japan] is the sheer amount of idle cash sitting on Japanese corporate balance sheets at a time when they are enjoying record profitability. This reflects the extent to which [Japanese] corporates had adjusted to deflation over a more than 20 year period.” [Emphasis ours.]

The Japanese, in other words, have already long been where the West now appears to be headed. On this analysis, and on any objective valuation basis, the stock markets of Japan and the US, for example, are almost polar opposites. By all means dance, but the location of the ballroom makes all the difference.