On Looking for Bubbles and the Benefits of Grains in your Diet!

From: aditya rana
Date: Sat, May 3, 2014 at 2:07 PM
Subject: On Looking for Bubbles and the Benefits of Grains in your Diet!

Hi!,

Is the U.S. stock market in bubble territory and therefore vulnerable to a steep correction? Following its lacklustre performance so far this year, investors are questioning the sustainability of the 150% rally in the U.S. stock market over the last five years. There is perhaps no one today who is better equipped to provide an insight into this key issue than the famed value investor- Jeremy Grantham (co-founder of the money management firm GMO)- who analyses the characteristics of bubbles in his latest quarterly note (https://www.gmo.com/Asia-Pacific/Research/Letters/). To summarise:

-Value investors must always invest on the basis of long-term values and long-term risks, and therefore endure the psychological pain of living through a bubble period – i.e. loss of client respect (which hurts) and loss of peer group respect (which irritates).

-GMO started looking at the characteristics of bubbles seriously in 1997, and identified 28 bubbles (since 1925) which had all ended badly, with prices reverting to the trend (and remaining below it for a while) which had existed prior to each bubble.

-They devised a simple rule to identify a bubble – a two-standard-deviation (or 2-sigma) move up in prices over the trend-line, which is likely to occur only once in 44 years. There were 330 such examples, which included minor bubbles as well as 28 major ones.

-The six most important bubbles in modern times, as depicted below in the chart below, all had crossed the 2-sigma benchmark with some even reaching a 3.5-sigma level (the U.S. Housing bubble of 2008!).

-What was really unique about the 2008 bubble was the near universality of the bubble – including major stock markets around the world, almost all real estate markets, oil and most commodities, junk bonds , art, land and forestry.

-The above point can be illustrated clearly by analysing long term data for 40 global equity markets, which shows that 2007 had the highest percentage of global equity markets at higher than the 1-sigma hurdle (a once in 6 years event) than at any time during history (see graph below).

-Looking at the U.S. stock market today, it is only at about a 1.4-sigma level (see chart below) based on both the two most reliable indicators of long-term value: Tobin’s Q (price to replacement value) and Shiller P/E (current price to the last 10 years of inflation-adjusted earnings). To get a 2-sigma event the S&P would need to reach 2,250 (20% up from current levels) – is that likely to happen?

-To answer that question one has to look at the underlying cause of the spate of bubbles in recent years – a phenomenon which can now be called the "Greenspan-Bernanke-Yellen put". The impact of the Fed’s put is best illustrated by the concept of the Presidential Cycle as shown in the table below, which demonstrates the vastly superior average performance of the stock market (and its riskiest component) during Year-3 of the Presidential Cycle (since 1964).

-If an investor employed a strategy of buying on October 1 and selling at the end of April during Year-3, the investor would make almost all the returns which occur over the full four years (see table below). This phenomenon is global with all the major developed world stock markets significantly outperforming during Year-3 of the U.S. Presidential Cycle (see table below).

-Why has this happened? While interest rates and money supply did move in a supportive way during Year-3, the amounts were small and could not have been the main driver of the superior stock returns. The data points strongly to "moral hazard" as being the key catalyst – i.e. in Year-1 and Year-2 investors are on their own, while in Year-3 (especially) and Year-4 the Fed will bail out investors if there is a crisis.

-There exists a clear history of bailouts in recent years – from the bond market tumble in 1994, the Asian crisis and the LTCM crisis in 1997-1998, the Y2K scare, the 2002 Internet crash (where the market bottomed 10% over the trend-line due to Fed support – rather than breach it as in every bubble crash previously) and finally the 2008 Financial Crisis.

-While purist value managers tend to stay out of the later stages of a bubble, they are vastly outnumbered by the momentum managers who continue to drive markets up during the final stages of a bubble.

-In addition to the Presidential Cycle, the January rule has worked well over the years – i.e. when the stock market was up during the first five days of the year and for the month of January, it tended to be up for the whole year (22 times since 1932 for an average gain of 11.6%). Conversely, when the market was down over the first five days and for the month of January, the market tended to be down for the year (14 times for an average loss of -6.6%). Based on these two rules, 2014 has poor prospects being both Year-2 of the Presidential Cycle and a "down down" year under the January rule.

-The reason why these two simple rules seem to work so well is that few investors take them seriously as they seem to be too simplistic, trivial, data mined and therefore have career risk for professionals. Individuals, in contrast, probably are not attracted adequately by the outperformance. While Grantham himself has not followed these rules over the years – being older and having less career risk today, for his personal portfolio he does reduce his exposure somewhat during "down down" years and increase it during Year-3 of the Presidential Cycle.

Best Guess for the next two years:

-This year should continue to be difficult, with the market being equally likely to be up or down, until October 1.

-The market is likely (over 50% chance) to have a strong rally from October 1 until April, and exceed the 2,250 level by then or in the subsequent 18 month period until the elections.

-After the elections, the bubble will burst with the market halving in price to revert to trend, and could even be worse depending on what the Fed does to support the market.

Fascinating insights (as usual) from Grantham who has the experience, track-record and wisdom accumulated over many years to be taken seriously. As he has noted previously, the only advantage an individual investor has over the professionals is patience – but that advantage is unfortunately given up too easily as investors get caught-up with the herd. In addition to this key advantage for individuals, I would add the tremendous benefits of being able to be a contrarian, not having "career risk" and not being overly concerned with intellectually sound arguments but looking closely at data and following even seemingly simplistic and trivial rules!

We are clearly in the late stages of a 5-year bull market run in the U.S. (see the chart below for another classic sign – institutional investors reducing equity exposure with retail buying), which might continue for a year or two more, but it would be prudent to trim down exposure to the U.S. market over the course of the year. However, as I have said in previous missives, EM have vastly underperformed developed markets over the last three years and are overdue relative outperformance over the next few years (and signs are that might have already commenced). In addition, Europe (core as well as periphery) and Japan should continue to perform relatively well – particularly as the ECB engages in a QE program and Japan steps-up its monetary easing.

However, a cautious stance is probably warranted as we move into the second half of the year as the likelihood of a Fed signalling a rate hike sometime in 2015 increases with a steady recovery in the U.S. economy. Though, as Grantham points out, the ensuing setback in the market is likely to be temporary given the tendency for the Fed to be market supportive (and market expectations of a Fed bailout) during Year-3 of the Presidential Cycle.

The Benefits of a High Fibre Grain Diet:

Came across an interesting study which shows the strong relationship between consuming a diet high in fibre from grains and a lower risk of death following a heart attack. In recent years, grains have been under attack from the low-carbohydrate and no-gluten diets which seem misguided (unless one suffers from gluten allergy in which case have rice!). Grains have been the mainstay of diets for most populations around the world since the advent of agriculture (and the subsequent flowering of human civilization) about 10,000 years ago and should constitute the foundation of a daily diet as they provide sustained energy, essential nutrients and fibre. Fibre, especially fibre from grains, decreases systemic inflammation, lowers bad cholesterol, improves insulin sensitivity, and enhances healthy gut flora. High-fiber foods are also high in vitamins, minerals, antioxidants, and phytochemicals — all nutrients that are beneficial to health.

Medscape April 30, 2014:

http://www.bmj.com/content/348/bmj.g2659

-Data from two large US cohort studies are providing some of the first solid evidence that increasing fibre consumption can increase survival after heart attack.

-The study was carried out by researchers from Harvard School of Public Health, Brigham and Women’s Hospital, and the Beth Israel Deaconess Medical Centre in the US, and was funded by the US National Institutes of Health and published in the peer-reviewed British Medical Journal.

-The message, according to one of the study authors, is that it’s not "too late" to add in fibre after a lifetime of eating less fibrous foods than recommended.

-The team reviewed data on men and women from the Nurses’ Health Study and the Health Professionals Follow-up Study who were free of heart disease at start, suffered a heart attack over the follow-up period, and completed dietary questionnaires both pre- and post-heart attack. Sensitivity analyses were conducted to control for physical activity, frailty, medications, and other factors.

-In all, 2258 women and 1840 men in the two studies had heart attacks during follow-up (as well as the data). Of these, 336 women and 451 men died at a later date during the 32 years and 22 years follow-up, respectively (an average of 8.7 and nine years).

-For both sexes, a post-heart attack increase in fibre consumption was associated with a reduced risk of death after age-adjusted analyses that held up after further adjustment for lifestyle and diet. After adjusting for other factors, every 10-g/day increase in fibre was associated with a 15% reduced risk of mortality.

-Subjects who consumed the highest amount of fibre in the top quintile (intake 27.4 g/day) were 25% less likely to die of any cause than subjects who consumed the least fibre in the lowest quintile (12.95 g/day), after adjustment.

-They also looked at fibre type and determined that cereal fibre, but not fruit or vegetable fibre, was "strongly inversely associated with lower all-cause and CV mortality." The same superiority for cereal fibre has been seen in other research.

Here’s to incorporating whole grains into every meal of the day!

Regards,

Aditya

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