Grantham on Fed Policies and Bubbles, Bubbles Forever, China Reforms, Scientific Proof of the Benefits of Yoga & Meditation!

From: aditya rana
Date: Sat, Nov 23, 2013 at 2:12 PM
Subject: Grantham on Fed Policies and Bubbles, Bubbles Forever, China Reforms, Scientific Proof of the Benefits of Yoga & Meditation!


With the U.S. stock market recently reaching record levels, it would be prudent to evaluate whether we are in bubble territory and what it might portend for future returns. To make this a useful exercise it is critical to have a value framework drawn from long experience and the lessons of history, and no one does this better than Jeremy Grantham, who runs the well known value money manager GMO. His latest quarterly note ( is (once again!) a masterpiece – to summarise:

Part 1: Bogus economic theories and bubbles:

-The theory of Rational Expectations, and its offshoot the Efficient Markets Hypothesis (EMH), relying on false assumptions and overturning decades of valuable mainstream economic work, argued that investment bubbles were unable to occur.

-However, the past 25 years have witnessed four of the largest bubbles in all of investment history: 1) the Japanese stock bubble which peaked in 1989 at a P/E ratio of 65, far in excess of a historical peak of 25, and subsequently crashing by almost 90%, 2) the Japanese land bubble which peaked in 1991 and was possibly the largest bubble in history (and subsequently crashed by about 90%) , 3) the U.S. equity bubble which peaked in 2000 at a P/E of 35, higher than the peak of 21 in 1929, and finally, 4) the first truly global bubble of 2008 which covered all global stocks, fine art and almost all real estate – led by U.S. housing – a crash of which the EMH had argued was a one in a 10,000 year event.

-The EMH theorists provided justifications for these (and other) bubbles – i.e. providing 12 reasons why the 22% one day drop in the U.S. stock market in 1987 was rationale response to a changed world, that Japan at 65 earnings was justified by accounting errors and low interest rates, and that the Tech Bubble permanently increased productivity.

-In the midst of this morass of false assumptions, recent Nobel Laureate Bob Shiller tried to show (in 1981) the inefficiency of markets by showing that historical markets consistently deviated from fair value (derived from discounting known dividend streams at known discount rates). Shiller also famously warned about both the 2000 Tech Bubble (with the release of his book "Irrational Exuberance" in 2000) and the housing bubble.

-The "fair value" of the market, two-thirds of the time, is within ±1% of its long term real trend of 1.5% per annum, but the S&P 500 is within ±19% of its trend two-thirds of the time – i.e. it is about 19 times more volatile than what is justified by underlying fundamentals (see chart below). This phenomena is mainly driven by the destructive "herding" instinct of both individual and institutional investors, relying on "extrapolation" of the past to make predictions about the future.

-As Keynes described so well many years ago, extrapolation dominates the workings of markets. One of the best examples of this is the peaking of the 30-year bond yields at 16% in 1982, with inflation temporarily spiking to 13%. The 30-year bond yield implied that inflation would remain at those levels for 30 years – despite it being obvious as an outlier event. More recently, the market extrapolates low inflation for 30 years. The stock market also tends to extrapolate indefinitely, the ups and downs of profit margins, producing volatility in prices which far exceeds its fair value.

Part 2: Fed policy and bubbles:

-The crash of 2008 is widely attributed to excesses in finance, but tends to overlook two important factors in the real economy: commodity price rises and the housing bubble. The remarkable rise in commodity prices – with oil increasing 8 times in nine years, and most of the rise occurring in the year prior to mid-2008, reduced U.S. growth by 5% spread out over six years (with about half of the effect taking place in the year prior to mid-2008).

-The housing bubble had the makings of a classic bubble (see chart below), despite assurances from the Fed that it was a rational response to a strong economy, and would involve a loss of $8 trillion of perceived wealth, most of which was borrowed against. A unprecedented extra 3% of the population had been induced to buy property despite the lack of growth in household income and real wages since 1970.

-The combination of one of the two most painful commodity price impacts on the economy in a century, and a giant $8 trillion loss in wealth (not including various secondary and tertiary effects), a deep economic setback and slow economic recovery was virtually guaranteed. The role attributed to finance was exaggerated and reflects our own bias favouring the paper world over the far more important real world.

-The excessive stimulus policy of the Fed will continue for a while longer under Yellen, leading to higher markets over the next one, and more likely, two years (with the U.S. up by 20-30% and the rest of the world, including EM, rising by even more in a partial catch-up). There have been few other occasions when broad disappointment with global economic growth has allowed the stock market everywhere to move higher.

-There is a growing risk that the slowing global growth (in Europe but also elsewhere) overwhelms the best efforts of the Fed, given the declining fiscal stimulus globally. This is a one in four likely event over the next two years.

-There are few signs of a current bubble in equities – U.S. individuals are not yet consistent buyers of mutual funds, CNBC talking heads are not promoting obscure stocks like they did in 1999 and there are no wonderful theories justifying the high P/Es as there were in Japan in 1989 and the U.S. in 2000 (with the exception of the indefatigable Jeremy Siegel arguing that the currently high margins are now normal).

-There has been a clear rise in the speculative element since the summer doldrums – reflected in the Russell 2000 outperforming the S&P by 6% and quality stocks lagging the market. This is likely to continue, leading to a badly overpriced market and bubble conditions, culminating in a third serious market bust since 1999 (subsequently prompting yet another rescue operation by the Fed).

-Being prudent and reducing risk will probably mean foregoing gains, and being risky will probably result in further gains, but you run the risk of eventually being "bushwhacked"!

An important and deeply insightful note which should serve as a serious warning shot about the rising risks in global markets. While it may be early to start reducing risk aggressively, rebalancing portfolios in favour of Europe and EM versus the U.S. is a prudent strategy over the next several months (see the latest 7-year forecasted returns from GMO). As noted in last week’s newsletter, the second half of 2014 is probably the time to commence a more aggressive de-risking – particularly (and perversely!) if we get above trend growth in the U.S. over the first half of 2014, which would bring forward the timing of the eventual reversal of the Fed’s rate policy ("The shot likely to be heard around the world"!)

Bubbles Forever?

Larry summers made an important (and widely discussed) speech at the recent IMF conference, which posits the notion that the U.S. (and the developed world) could be in for a period of "secular stagnation" for the foreseeable future. In the context of Grantham’s note, I present below some pertinent comments from Paul Krugman on the speech:

-"We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.

-So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles? But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?

-So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest.

-And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s. One way to quantify this is, I think, to look at household debt. Here’s the ratio of household debt to GDP since the 50s:

-There were about 25 years of rough stability, from 1960 to around 1985. After that, however, household debt rose rapidly and inexorably, until the crisis struck. So with all that household borrowing, you might have expected the period 1985-2007 to be one of strong inflationary pressure, high interest rates, or both. In fact, you see neither – this was the era of the Great Moderation, a time of low inflation and generally low interest rates.

-Without all that increase in household debt, interest rates would presumably have to have been considerably lower – maybe negative. In other words, you can argue that our economy has been trying to get into the liquidity trap for a number of years, and that it only avoided the trap for a while thanks to successive bubbles. And if that’s how you see things, when looking forward you have to regard the liquidity trap not as an exceptional state of affairs but as the new normal."

China Reforms:

The recent reforms announced by China have the potential to become a watershed event for China – reversing a decade long period which saw reforms stagnate. Morgan Stanley provided a good summary of the main points (see below), and given that the Chinese stock market is currently trading at close to historically low valuations, it would be a good time to start accumulating some exposure to the Chinese stock market through funds and ETFs.

-"Morgan Stanley believes the release of a comprehensive reform guideline signals a positive outlook on reforms, as the content is very specific and much more aggressive than expected:

1) It sets important directions to allow market force to dominate resource allocation and aims to level the playing field between SOEs and non-SOEs.

2) To see “decisive results” by 2020, the government will likely pace the concrete measures in several areas (fiscal, financial, land, Hukou, SOE, and demographics) annually with more focus on timing of the implementation than before.

3) The announcement from President Xi demonstrates his full endorsement of this document and strong support of reforms."

Scientific Proof of Yoga & Meditation Benefits:

By Makiko Kitamura – Nov 22, 2013

-Scientists are getting close to proving what yogis have held to be true for centuries — yoga and meditation can ward off stress and disease.

-John Denninger, a psychiatrist at Harvard Medical School, is leading a five-year study on how the ancient practices affect genes and brain activity in the chronically stressed. His latest work follows a study he and others published earlier this year showing how so-called mind-body techniques can switch on and off some genes linked to stress and immune function.

-While hundreds of studies have been conducted on the mental health benefits of yoga and meditation, they have tended to rely on blunt tools like participant questionnaires, as well as heart rate and blood pressure monitoring. Only recently have neuro-imaging and genomics technology used in Denninger’s latest studies allowed scientists to measure physiological changes in greater detail.

-"There is a true biological effect,” said Denninger, director of research at the Benson-Henry Institute for Mind Body Medicine at Massachusetts General Hospital, one of Harvard Medical School’s teaching hospitals. “The kinds of things that happen when you meditate do have effects throughout the body, not just in the brain.”

-The government-funded study may persuade more doctors to try an alternative route for tackling the source of a myriad of modern ailments. Stress-induced conditions can include everything from hypertension and infertility to depression and even the aging process. They account for 60 to 90 percent of doctor’s visits in the U.S., according to the Benson-Henry Institute. The World Health Organization estimates stress costs U.S. companies at least $300 billion a year through absenteeism, turn-over and low productivity.

-His current study, to conclude in 2015, tracks 210 healthy subjects with high levels of reported chronic stress for six months. They are divided in three groups. One group with 70 participants perform a form of yoga known as Kundalini, another 70 meditate and the rest listen to stress education audiobooks, all for 20 minutes a day at home. Kundalini is a form of yoga that incorporates meditation, breathing exercises and the singing of mantras in addition to postures. Denninger said it was chosen for the study because of its strong meditation component.

-Participants come into the lab for weekly instruction for two months, followed by three sessions where they answer questionnaires, give blood samples used for genomic analysis and undergo neuro-imaging tests.

-Unlike earlier studies, this one is the first to focus on participants with high levels of stress. The study showed that one session of relaxation-response practice was enough to enhance the expression of genes involved in energy metabolism and insulin secretion and reduce expression of genes linked to inflammatory response and stress. There was an effect even among novices who had never practiced before.

-Harvard isn’t the only place where scientists have started examining the biology behind yoga. In a study published last year, scientists at UCLA and Nobel Prize winner Elizabeth Blackburn found that 12 minutes of daily yoga meditation for eight weeks increased telomerase activity by 43 percent, suggesting an improvement in stress-induced aging. Blackburn of the University of California, San Francisco, shared the Nobel medicine prize in 2009 with Carol Greider and Jack Szostak for research on the telomerase “immortality enzyme,” which slows the cellular aging process.

-Not all patients will be able to stick to a daily regimen of exercise and relaxation. Nor should they have to, according to Denninger and others. Simply knowing breath-management techniques and having a better understanding of stress can help build resilience.

Here’s to 5-10 minutes of daily yogic breathing (gentle breathing using the stomach and visualising the breath moving from outside the nostrils into the stomach and exiting via the same route) for starters! It’s quite simple!




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