Apr

16

 The Collaborator and I recently had dinner with Louis Gave, one of the three principals of GaveKal, and found ourselves in agreement about almost everything in the world of markets, even though we had reached our conclusions by completely different means. The amazing thing was to find Louis talking about the weaknesses of such things as the Shiller predictive work on returns based upon 10 year averages, the importance of the February 27th decline as the key to a bullish future, the differential between bond yields and earnings price ratios as an upward driver, and the coming under performance in commodity prices.

After we left the meeting, Louis and I crossed emails, with me telling him that the Collab. and I agreed that the smartest thing that kids could do was wait for a big decline in the market and then buy a distant futures contract, or spider, and roll and hold forever. Louis wrote that he planned to buy some long term calls on the Hang Seng next time there was a big decline and invest the billions of ultimate profits in land for the kids.

I wish to say up front that it is embarrassing in a sense to trumpet the agreement of someone widely respected like Louis, who runs a big and important business that has put clients with many hundreds of billions under management with the weather gauge, and myself who is a poster boy for how to take undue risks. And yet, because I like to fan that image I thought I'd take a crack at memorializing some of the things that I know something about, on which our consilience was based. I immediately point out however, that there is no reason to believe that anything I say about macroeconomic policy or Asian markets or the dollar has any positive or predictive information content, and I am truly embarrassed to find myself in agreement with Louis based on my views on those specific matters (as opposed to the one or two things I do know about) since as far as I can tell Louis and his team have done about as much good as the weekly financial columnist has done harm.

Gavekal produced an ad hoc comment dated April 4th named 'Why we remain bullish', in which Louis points to five trends as the cornerstone of his belief. In a previous back and forth on this site with Louis he kindly offered limited availability to our readers for his reports, but I will summarize this particular one here. The backdrop is that he finds that the wisest people he knows agree that they should all have been more bullish during the last 5 years, but now they are worried that prices are too high. He believes however that the trends in the world economy are better than ever now because of globalization, emerging markets finally emerging, a financial revolution becoming established, and montetary policy is now on the right track. As for gloablization he has some nice quantitative work showing that volatility of output in the US has decreased markedly in the past 25 years,and as a consequence corporate profit margins have gone from the lower left to the top right of the chart. He elicits a host of factors ranging from increased trade with Asia, to the movement towards a knowledge based economy.

While I am not knowledgeable enough to appreciate fully the implications of his platform company model, or monetary base adjusted for volatility, we found ourselves toasting each other on the idea that rational expectations is such that there is no reason to believe that bankers and consumers always do the wrong thing. Quite the contrary, they are behaving very rationally considering the enormous increase in wealth that has been generated from increases in asset prices like bonds, stocks, and real estate.Louis has an infinite amount of what seem to me insightful ideas about how interest payments and corporate taxes are much less, and therefore profits have much more mojo in the future. However, as he puts it "most importantly our economy has evolved to a knowledge based economy where one only needs ideas and good people, and from these the returns can be enormous."

Next they cover the emergence of emerging markets with many beautiful charts about industry, agriculture, education, investments, expressways, and productivity in China. For obvious reasons I am not competent to comment on the predictive accuracy of such charts.

Next, the financial revolution. He has a startling chart showing that mortgages as a % of real estate values are very low all over the world except in the U.S. and the Netherlands, and he points out that if the trends to increased mortgage in various countries continues, unfathomable spending and better deployment of assets will be released. It is in the area of the financial revolution that Louis comes up with the shocking statement that the February 27th decline is a key to his bullishness. He believes that when huge declines like this are quickly reversed it shows the resilience of the financial system. My contribution to this is the tested assertion that after startling declines, anything that looks like it has the slightest similarity to the preconditions of the past decline is a high expectation relative to risk buy.

I believe that in one day, the February 27th decline duplicated the whole pusillanimity of the spring of 2006, the summer of 2002, and yes, the aftermath of October 19th, 1987 after which all big Friday declines led to to so much more gain on the subsequent Monday than the decline of the terrible day itself.

Louis has a nice table of the kinds of things that chronic bears have predicted during the last five years, and shows that they have happened and the market has withstood them with aplomb. I would point out what we have shown in our bear corner often that what has happened negatively in the past 10 years, has happened in the previous 100, in each of the years, and that conditions are not any more negative now than during the Dimson 10,000 fold return century.

Amazingly Louis had come to his conclusions about the resilience of returns and the case for long term bullishness without reading the Dimson work, which probably is a plus since the great triumvirate in my opinion suffers from a certain belief system all too common in France as opposed to the entrepreneurial ethos in Siliconia.

Another plank in the Louis case for bullishness is that we are going to have lower inflation in the future. He has many simple facts and tables about the trade balance and the hypotenuse of, to me a G and S, nature that support his point. I always find it amazing that with all the brain power devoted to fixed income  anyone could believe that they could come up with a better forecast of where inflation could be than the long term bond rate, which gives a 3% or so expected real return and at 4.7 % is consistent with 2% a year inflation.

A final trend that follows from this in the Gavekal analysis is that because bond yields are so much lower than earnings yield, that all sorts of liquidity will come in to buy stocks from such sorts as private equity funds, and pension funds. Our own work on the differential which is posted in our quantification of the Fed model with actual prospective forecasts of e/p as the basis, shows that during times like these when the forecasted earnings yield (without regard to its accuracy) is a few % over the bond yield, the expected rate of return on stocks is some 20% a year, with an incredibly high accuracy. Amazingly again, Louis had come to the same conclusion based on qualitative analysis of such things as the actual level of savings in the US ("Why do we have all the big mutual funds, the Fidelities, the Alliance capitals, and the Vanguards in the US if the US isn't saving").

I cannot begin to do justice to the Gavekal case for bullishness except to say that I would consider his book "The End is not nigh" one of the 6 most important and helpful books for the investor to own, and that in the course of a rather encompassing career of over 50 years on Wall Street, and in the groves of academia, I have not come across any individual, (except for my friend from Mount Lucas), with sounder insights into the forces that shape investment returns.

Allen Gillespie adds:

Long bonds are not the only markets with implicit inflation forecast. The currency markets clearly have a relative inflation expectation as do the gold market. I would posit that gold, which has risen $140 since helicopter Ben became chair (that would be up at a 13% annual rate), or the dollar index which has fallen at a 7% rate, are telling us something about long term inflation expectations that are in opposition to long bonds.

This is not to say that higher inflation rates are clearly bearish, or that bonds are necessarily wrong, but to point out that the long bond's 2% expectation, which is consistent with the Fed's expectation, may be standing in opposition to other forecasts which may prove more accurate. In fact gold at $680 up from $20.67 in 1900 computes to a 3.3% compounded inflation rate. At the peak in 1980, gold implied a compounded rate closer to 5%. Gold has been rising at a 13% rate since the new chair, and I do not believe this should be ignored. I posit that a new high in gold would complicate the Fed's calculations.

In addition, momentum screens currently are being dominated by inflationary and recessionary sectors, and arbs (which tend to rise during market stress, because of their fixed income, like return profiles).

George Zachar remarks:

The Dallas Fed agrees with the Specs and GaveKal,

As knowledge spreads in our globalizing economy, it unleashes powerful forces that redefine fundamental economic relationships.

In one industry after another, lower transportation and communication costs have knit together far-flung companies and workers, expanding local markets into worldwide ones.

A more integrated global economy generates new competition, identified since the days of Adam Smith as a key to delivering more output at lower prices.

Larger markets bolster incentives for innovation, the wellspring of economic progress. They open new possibilities for specialization, which channels factors of production to their most efficient uses.

Globalization boosts foreign investment by freeing scarce capital to seek its highest return anywhere in the world. Companies can find and manage a broader range of inputs, the raw materials for more efficient production methods.

Where fixed costs are high and marginal costs low, globalization extends economies of scale to output levels beyond the scope of national markets. The connection of competitors and capital from all parts of the world reduces entry barriers in high fixed-cost industries, eroding the monopoly power that keeps prices high.

Knowledge and technology spread more readily, loosening the restraints that shackle progress. Production becomes more efficient…

From Russell Sears:

This may be blasphemous for the gold bugs, but:

Gold is a physical commodity, which historically has implied wealth. When my maternal forefathers fled Russia, invading northern Finland, with as much gold as they could carry, it was due to inflation expectations of currency. Now when gold is hoarded, it is more likely due to the bling factor, not that US currency can't be trusted due to the inflation expectations.

In fact I would argue the opposite. The last 25 years have trained most to think the feds will always be pushing inflation down on the whole. But this causes pockets of inflation and deflation to spring up. Gold, like most items purchased to advertise your wealth, is experiencing high inflation, as the pool of wealth has spread. Gold is still a hedge for the wealthiest against inflation expectations, but not the economy as a whole.

Rather than a sign of coming Armageddon, it's a sign of spreading capitalism.

Nigel Davies adds:

One minor point after a mere six weeks cogitation, is that it seems like quite a contradiction to believe that consumers act rationally here but that the public always acts wrong where stock purchases and sales are concerned. Especially when one considers that stock buyers are likely to be relatively sophisticated individuals compared to the man on the street with a credit card.

I suggest that they will act more or less like sheep in both cases. Perhaps the difference with stocks is that someone may try to deliberately mislead them rather than participate in the shared risk of them overspending. 


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