Jeremy Grantham Speaks

Set Aside Fears of Inflation -- Just for Now

CLIENTS CAN ALWAYS COUNT ON RAY DALIO AND HIS TEAM at Bridgewater Associates to consider every angle in sizing up the global financial condition and find money-making positions, no matter what the environment. With a special focus on the global credit and currency markets, the firm manages about $75 billion from its base in Westport, Conn. -- for governments, central banks, pension funds and endowments. Recently, a lot of attention has been paid by various bloggers to certain offbeat management practices at Bridgewater that -- quelle horreur! -- en-courage truthfulness and openness and constructive criticism as a means to excellence. A better focus might be the firm's outstanding performance. What Dalio is focused on at the moment is as follows.

Barron's: We last spoke in February 2009, exactly a month before the bottom in the U.S. stock market. A lot of money has been printed.

Dalio: Governments always print money. Last year was very similar to March of 1933, although we hadn't contracted for nearly as long, and the Federal Reserve was much quicker on the trigger. They didn't let the economy get so bad; they moved a lot faster and in large quantities. The whole world did -- all the major central banks and all the major governments did what was done in March 1933. Classically, there is big monetary stimulation and big fiscal stimulation, and we had that globally in a magnitude that we had never had before.... It caused the stock market to retrace about 60% of its decline, and it caused the U.S. economy to retrace 40% of its decline. But it did not produce new financial assets. There has been very little new lending. The stimulus produced very little in the way of economic activity.

A year ago you thought it wouldn't be until late 2010 that we would get the best opportunity to buy stocks.

The government response was quicker and larger than I thought it would be. But the boundaries of the old highs and the boundaries of the lows in the stock market and in the economy will be with us for a long time. If there were to be a decline in economic activity below the prior low, it would be intolerable, and central banks would print money again. The risk to that right now is that public sentiment has turned more negative about perceived bailouts. There is a lot of criticism about saving financial institutions and running a big budget deficit, but if the government didn't do those things we would be in a terrible situation. It will be impossible to stimulate that way in the future because politically it is untenable. That's a risk because, between now and 2012, the economy will probably go down again, and it will be important for monetary policy and fiscal policy to be able to be stimulative, and for the Federal Reserve to be able to purchase assets again.

Are you suggesting we will experience something of the magnitude of 2008-09?

No, that won't be allowed to happen again, although, inevitably, there is another recession out there. It will probably come sooner than most recessions do. Usually, there is about five years between recessions, but for various reasons related to the size of the debt, the next recession is going to come sooner. We are in the equivalent now of a quantitative easing-induced cyclical recovery. But it is a fragile recovery, and credit growth is not picking up very much, and it goes back to the fact we still have too much debt. We have not reduced our debt burdens in any way significantly. What we've done is to largely roll them to the vicinity of 2012 to 2014. Corporate balance sheets are much, much better because they extended the maturities of their debt and slashed expenditures by laying off workers. I would be shocked if we saw new lows in the economy, but you can't go to new highs anytime soon, either.... The average American's net worth is less, and incomes are less and so the amounts they can leverage will be less -- so for a long time spending rates will be less than they were at the peaks.

How do you view current developments in Europe?

Europeans are faced with the same three choices we were facing in dealing with debt -- print money, redistribute money, or restructure. The European situation is a particularly risky one for a number of reasons. One, the size of the debt dwarfs that of any other debt crisis. It dwarfs the Latin American crisis. It dwarfs the Asian Contagion. These are enormous, enormous amounts. A lot of attention is paid to the sovereign debt, but there are also big private-sector debts. It doesn't make much difference whether it is government or private, there is way too much indebtedness in these countries....

It's a very frightening situation because there is a risk here that the Europeans will not move decisively or quickly enough. There is a pulling back of capital at a time when the need for capital is greater. There is rollover risk. Spain, for instance, has to roll over 40% of its external debt, which is about $700 billion to roll over, and because it is running a current-account deficit, it actually has to borrow more than that, which is almost another $80 billion. Just the government has to roll over about 20%, or about $125 billion. Spain will have to borrow more than it has ever borrowed before in the next year at the same time as people's inclination to lend to Spain is reduced. The government debt of all the peripheral countries in the euro zone that has to be rolled over in the next three years is the equivalent of $1.9 trillion, and that doesn't include the private-sector debt.

What's your response to the International Monetary Fund program with the European Union?

It is a good program. It lines up nearly a trillion dollars and puts the IMF in a leadership position. However, it is doubtful whether the European Union will allow the IMF to take an unimpeded leadership role in arranging debt-adjustment programs. Even if they do, the process will be painful because, any way you slice it, countries in the euro zone have to cut expenditures. It will be painful for Europe for 10 years in the way it was to Latin America and Japan. The British will happily say, "Thank God we have never joined the euro zone." The English also have way too much debt, but they have an independent currency and can print money and avert a debt crisis. Debtors with no ability to print money are the ones in trouble.

What's your view on emerging markets?

The emerging world has not reached its debt limits and is competitive because labor is cheaper and there are high levels of investment. They're roaring ahead. They are at new highs in economic activity. Yet, we are tied together with the same monetary policy because China has a currency peg to the U.S., essentially linking our interest rates. We are also tied together through trade and investment.

The emerging creditor countries should be tightening monetary policies, but their ability to do that is limited by exchange-rate linkage. Here is China, with a nominal growth rate of 12%to 14%, with interest rates about the same as ours. In China, it is a sure thing you don't want to deposit your money to get that interest rate, and it is a sure thing you want to borrow and buy a piece of the economy.

But China has made some attempts to tighten.

Yes, they are moving to tighten without significantly changing interest rates. They are raising reserve requirements and they are imposing administrative controls, essentially trying to limit bank lending. They are trying to control credit, but they are having a problem controlling the creation of money. The risks of tightening increase as time passes. They will, in one fashion or another, tighten more and more. But I don't think there will be a major change in the exchange rate, even though it is in their interest.

You have been concerned about U.S.-China relations.

We are entering a period of time in which relations will be more challenging for the U.S. and China. It isn't healthy that the two biggest countries in the world have a very big debtor-creditor relationship. There is going to be a tendency by both countries to blame each other and be antagonistic. There will be trade disputes and currency disputes. I don't think the deficits will be resolved, but I think there will be growing protectionism in the U.S., and implied threats by the Chinese regarding capital flows.

How are your portfolios positioned?

Our portfolio is mostly skewed to Treasury bonds, gold and emerging-market currencies, especially Asian currencies. We also hold commodity assets that are limited in supply and that high-growth emerging countries need. I want to minimize my exposure to the major developed countries' currencies -- the U.S. dollar, the euro, the British pound and the yen -- because those countries have a lot of debt, and they are going to need to print more and more money and will have more sluggish growth rates. I prefer the yen to the others. However, none of these can get too far out of line with the others, and when there is downward pressure on one, there is pressure on all. Just as the notion that the G-7 countries represent the major world powers is obsolete, it is also an obsolete notion that their currencies are the major reserves of wealth.

The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon.

Explain why the printing of money won't cause inflation.

The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth. For example, in March of 1933 the U.S. printed a whole lot of money, and that had the effect of converting deflation into modest inflation, but not a high rate of inflation.... My point is, in developed countries there is too much of most things at the moment, and that's creating a deflationary environment. There is too much manufacturing capacity. There is too much labor. There is too much housing stock. As Europe's economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody's belief, I believe the bonds in countries that can print money will be good investments.

Thanks, Ray.

Link to the Article

Valuing Equities in an Economic Crisis or How I Learned to Stop Worrying about the Economy and Love the Stock Market

Having spent the last decade decrying stocks as overvalued despite what has generally been an extremely benign economic backdrop, some of our clients are a bit bemused to find us more bullish than many of their other managers today. After all, isn’t this the worst economic crisis since the Great Depression? If we could hate stocks when times were great, shouldn’t we hate them even more when the world seems to be going down the drain? But given our basic set of beliefs – mean reversion happens, the economy is driven by the skills of the workforce and the physical and intellectual capital of companies, equities are long duration assets – both stances are completely consistent. To us, the true value of the stock market changes very slowly and smoothly. It is the myopia of investors that causes market prices to vary so wildly.

In their recent panic, investors have driven U.S. equity valuations down below fair value for the first time in well over a decade. This is not particularly surprising given the economic environment, but we should not confuse a predictable event with a justifiable one. Given that we are in an economic crisis, investors were apt to overreact to the bad news and drive the market down, but we believe that this is not warranted given the underlying fundamentals of the market.

John Templeton’s famous line, “The four most dangerous words in investing are ‘This time it’s different,’” is usually taken to apply to New Era bull markets. But it is just as applicable in a bear market. Because the economy is a mean reverting system, things have never been as good as they appeared in the booms, and have never yet been as bad as they appeared in the busts. We believe that this time will not be different, and history, at least, is on our side.

Given our assumptions, fair value for the S&P 500 is around 900. Long-term investors in stocks should therefore do well if they invest at current levels. An investor who correctly guesses that the market will bottom at 600 and waits until then to invest will do even better. But that investor is taking the risk that investors overreact less to this crisis than they have in previous crises and, in waiting for the perfect entry point, may miss the best opportunity to buy equities in over 20 years.

Link to the Paper

Interview with Vitaliy Katsenelson (Oct2008)

What do you see as the likely scenario for the economy?
First, a Great Depression of the 1930s is not in the cards. The world will not suddenly lose its color and turn black and white (the colors that come to mind when we think about 1929 Great Depression, as there were not color cinemas then). No, we won’t have food lines, our kids will not start playing with bricks and sticks instead of toys and they will not be wearing handed down clothes several sizes their senior. Their collection of toys rotting in the attic may shrink and - I have to warn you – you may still see kids wearing torn jeans with holes that are too big for them. But don’t blame the economy, blame the latest fad. Our economy is stronger, more diversified, and far more developed than in the 1930s. It is unlikely our government will repeat the mistakes it made then. We also have a system of social nets, such as unemployment insurance (which will probably be extended, like it was in 2001 and 2002) and welfare.

I see three possible scenarios for the economy: (1) a Great Recession (2); a (semi-normal) recession; and (3) a quick recession leading to growth.

Our problems today stem from two sources (here I am oversimplifying a bit): an abundance of bad debt and a loss of trust in the financial system. Banks don’t trust their current or potential customers; investors and depositors don’t trust banks; and banks don’t trust each other. The government is trying to restore this circle of trust. Two months ago, socializing the financial system would have seemed preposterous. Now there is no way around this, at least temporarily. The Fed and Treasury are trying to restore trust by shoring up banks’ balance sheets and by stamping government guarantees on otherwise risky loans, and they will likely succeed.

The next step is dealing with the bad debt. Some of it will be socialized (paid for by the taxpayers). Some of the bailout programs will cost money, and some won’t. Warren Buffett says the government will make money on the CDO auction program, but I think this will depend on the price the government will pay for this debt.

The possibility of a Great Recession (which would be a steep decline in GDP growth and a sharp rise in unemployment, lasting a long time) is higher than in the past. The only reason a Great Depression would happen is if the “circle of trust: not restored.

The bottom line is, if the Fed is successful at restoring the circle of trust, a Great Recession is avoided.

We are very likely to be in a semi-normal recession. How long and deep will the recession be? We really don’t have a good benchmark to forecast the level of unemployment, nor the level of growth or decline in GDP, nor the duration of the recession. This is a consumer-driven recession and the consumer is two thirds of the economy. The last recession of 2001 was led by corporate slowdown; the 1991 recession was a consumer recession, but it was very different from current one. Housing prices did not decline nationwide; the consumer was not as leveraged and the global economy was in different shape. And yes, we are in a recession, no matter if it fits into traditional definitions. Growth is down and unemployment is up. The definition of a recession doesn’t matter.

A possibility of the third scenario – a quick and shallow recession leading to growth – is not high but it is there. For this scenario to play out the bulk of losses in financial sector need to be behind us.

What is your forecast for other world economies?
In looking at the external consequences of a global recession, I prefer to divide the world into four broad categories of countries: the US, Europe (and other developed countries), emerging markets, and commodity exporting nations (Russia and the Mideast).

As I mentioned before, the US will fare the best on a relative scale, because we are diversified. Despite the socialism which has transpired through the various bailout initiatives, we are still a capitalistic economy. Our capitalistic DNA will be only slightly (and hopefully only temporarily) diluted with socialism.

Europe is in a very interesting situation, one which will test the stability of the European Union (EU) and the long-term survivability of the euro. The EU consists of countries with strikingly different histories. Some have experienced runaway inflation and, for this reason, countries like Germany are very cautious about increasing monetary supply. To fight today’s financial crisis some countries will want to increase the money supply, and this will pit countries against one another. This also makes me less bullish on the euro.

Russia and the Middle East benefited from high commodity prices. If you look at Russia, for instance, the return on capital in oil- and commodity-related industries was much higher than in any other industry. This siphoned capital from other industries, which caused investments in these industries to decline. To make things worse, the rise of commodity exports drove up the Russian currency, making non-commodity industries even less competitive in the world market. Once you take high commodity prices away, Russia is worse off than it was before. On top of this, when Russia did well, it acceded to pressures to increase social programs. (In case of Middle East, they embarked on ambitious construction projects, like building a brand new city with a zero carbon footprint in the United Arab Emirates). Russia has created a stabilization fund (a super savings account), but I am not sure how long this fund will last. Russia is strong on a balance sheet basis, but that is a reflection of the past. The future, as reflected in its future income statements, looks horrible. To some degree it is almost a mirror image of the US – our balance sheet is weaker but our earnings power is strong.

The Middle East is a very similar story to Russia - with a twist. It benefited from oil prices and spent a lot on infrastructure, like building out new cities. My concern is that terrorism came mostly from the Middle East, and I am unsure what will happen when poverty levels go up in these countries.


Are there any foreign markets that look attractive now?
It comes down to stock selection. For example, we are concerned about Europe, but we own a British liquor company that has better fundamentals, a lower valuation and higher yield than its American counterparts. It is likely to do better in this environment. Our biggest concern is the “stuff” stocks (industrials, energy, and materials). They were responsible for a good chunk of excess in corporate profit margins. The analysts’ earnings assumptions are way too optimistic. The only question about the recession is how big it will be and how long it will last.

As I mentioned before, it is a stock picker’s environment. We don’t know how long this drama will last, and thus we are not trying to be heroes.

Full Interview Transcript

Inflation Not The Problem

In the cacophony that is global investment strategy research, Albert Edwards and James Montier stand out as clearly distinctive voices. And not merely because of their British accents or because they’ve tended to the decidedly bearish side of the scale over the last decade or so. Despite long tenure in the rarified top echelons of the investment banking world, for many years with Dresdner Kleinwort and more recently at Societe Generale (where they are co-heads of global cross asset strategy) both have managed to retain a natural plain-spoken bluntness. Also large dollops of common sense and strong streaks of reflexive independence, which they employ in conveying their often invaluable insights on investment strategy. In Albert’s case, those spring mostly from his long experience in the dismal science of economics and in James’, from his explorations of the equally mysterious realms of behavioral neuroscience. They are, in a word, skeptics, and at this juncture most deeply skeptical of any and all notions that “the worst is over.” The recession, which has barely begun, is more likely to be deep than shallow, market valuations are hideously expensive and the -flation policymakers should be worried about starts with de-, not in-. For their reasons, keep reading, if you dare.

Yet I hear people all the time comparing valuations to the tech bubble and declaring stocks, “Cheap.” Isn’t there a neuroscience explanation for that behavior?

James: Absolutely. It’s classic anchoring. This whole habit of hanging onto irrelevant benchmarks. That’s exactly what you’re seeing. People say things like, “Well, 24-25 times Ford’s
earnings is perfectly reasonable.” That was the peak they reached in the bubble. Today, at 13
times, even if I believed the Ford earnings forecasts, which clearly we don’t, you’d have to
question whether those numbers are actually cheap. Relative to the peak in the bubble, yes.
Relative to a decent long-run history, clearly, no. That’s the problem. People have very, very
short-term memories here. We’ve got a serious myopia problem within the markets. The analysts are just in cloud cuckoo land. They keep telling us that things are going up. I do a chart
of actual earnings and forecasts, which shows that the analysts very clearly lack reality. They
only ever change their minds when there is irrefutable proof they are wrong, and then they
only change it slowly. It’s a classic pattern of anchoring and slow adjustment that we see.

Not to mention, demolish decoupling.

James: I actually have come up with a wee bit of data that shows, even if you somehow still believe in decoupling, that the emerging markets still have a huge problem: There’s an inverse relationship, historically, between economic growth and stock returns in emerging
markets. The slowest-growing emerging markets have generally generated the best stock
market returns for investors, while returns from the fastest-growth emerging markets have
lagged, because people overpaid for growth. Yet the whole reason, today, for buying into the
emerging markets and commodities seems to hinge on rapid growth in China, India, Brazil and
Russia — which I think is utter madness.

One thing I hear constantly, so you must, too, is that there’s still so much liquidity
looking for a home that the markets have to be sitting pretty.

James: We definitely hear a lot about liquidity and a lot about sovereign wealth funds. But along time ago I wrote that liquidity is the name that investors give to their ignorance, and I continue
to stand by that. When you can’t find anything else to explain what’s happening, you say it’s liquidity. You might as well say there are more buyers than sellers because it is at least as true, scientifically. A lot of what we see here is just excuses being made. A lot of it isn’t genuine monetary creation like Albert was talking about earlier is in the emerging markets context. A lot
of what you’re referring to is really the fallacy of liquidity, this idea that there’s a lot of money
sloshing around and it’s got to find a home. As our mutual friend John Hussman always points out, all you’ve got is really Paul selling to Peter. It doesn’t alter a damn thing if I buy a stock and
someone else sells it. The net amount of money entering or leaving the market is essentially zero.

Albert: What the “liquidity” everyone talks about really is, is leverage. If there’s price momentum, you want to borrow and play that price momentum — often in cyclical risk assets.
But as soon as that momentum turns, like the Roadrunner, liquidity may continue running off
the cliff for awhile, but eventually gravity takes hold. Prices re-couple with the cycle. And as
we’ve seen with CDOs, liquidity just evaporates overnight. That’s the problem with relying on
liquidity as an investment tool. It’s just basically a leveraged momentum trade, which can
explode in your face. Now, some of these private equity people are still able to raise money —
that’s what’s so amazing. But liquidity essentially can evaporate overnight, as we’ve seen with the CDO market.

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Down to the Last Drop of Profit Growth

STOCKS ARE ALLEGEDLY CHEAP NOW, at 17 times 2007 earnings. And they are cheap by historical standards. Only seven years ago, they were at price/earnings ratios double today’s; they are even cheaper if you compare their forward earnings yield of 6.7% to Treasuries’ yield of 4.25%. They are cheap, cheap, cheap! Or so we’ve been told.

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Many disagree that the profit-margin reversion will take place. Here are the most common arguments against it, and some food for thought on why “common” doesn’t necessarily translate as “wise.”

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Interview with the Author

Are we headed for an epic bear market?

Satyajit Das is laughing. It appears I have said something very funny, but I have no idea what it was. My only clue is that the laugh sounds somewhat pitying.

One of the world's leading experts on credit derivatives, Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years. He seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch -- and I expected him to defend and explain the practice.

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Random Gleanings: The Elusiveness of Clarity

There are always uncertainties. If you can’t find things to worry about, you lack imagination and a sense of history. But it’s also important to maintain the proper perspective between what’s unknown and what’s relatively certain. Right now, amid the unwinding of a credit crunch, the unknowns seem to loom larger and be more numerous than usual--but that’s typical of liquidity squeezes. What are today’s primary uncertainties?

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Get Off the Ledge

Unless you're in a highly leveraged hedge fund or running an investment bank, you have no reason to despair the turmoil on Wall Street.

Mortgage lenders are dropping like flies. Hedge funds are blowing up. Central banks are injecting money into financial markets to prevent a meltdown. Little wonder that many investors are fighting the urge to panic.

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How Speculators Exploit Market Fears

Here's a fact: The speculators and hedge fund managers who run today's stock market need market volatility in order to make money.

They can't make enough money if the market stays flat or moves only a bit, so they like extreme and unexpected price movements. They especially like sudden, surprise movements down, when they can make money off stocks they borrow and sell -- or, as they say, "sell short."

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