On Looking for Bubbles (Part II) and is Fish Good for You?!

From: aditya rana
Date: Sat, May 10, 2014 at 2:11 PM
Subject: On Looking for Bubbles (Part II) and is Fish Good for You?!

Hi!,

As a follow-up to last week’s newsletter on "Looking for Bubbles" which outlined Jeremy Grantham’s quantitative approach to identifying bubbles, I present below a more qualitative approach to identifying bubbles as proposed by his colleague, Edward Chancellor, a noted expert on historical bubbles and author of the classic book "Devil Take the Hindmost" which provides a history of financial speculation from medieval times to today. To summarise:

-Applying a non-valuation approach to identifying bubbles bodes ill for long-term investors in the U.S. stock market, which is currently flashing many of the classic warning signs.

-"This-time-is-different mentality": Throughout history , bubbles have been justified by the argument that the lessons of history are not relevant to the present situation – as during the 1929 and the late 90s TMT bubbles. The same applies today to U.S. profit margins which are at peak levels, and profits as a percentage of GDP are more than two standard deviations above their historical average.

-"Moral Hazard": Bubbles tend to form when there is a prevailing belief in the existence of a "central bank put" – i.e. the government will step-in to protect the downside in markets thereby encouraging investors to take more risk. This phenomenon appeared in the late 90s and became to be known as the "Greenspan Put" and, in the aftermath of the financial crisis, was implemented in full force resulting in U.S. household wealth reaching a record 472% of GDP, nearly 100% over its long term average.

-"Easy Money": Low interest rates have usually driven markets to bubble territory, and U.S. interest rates have negative for more than five years as the Fed has deliberately tried to boost home prices and the stock market. In particular, the reduction in the long term discount rate has boosted the value of growth stocks around the world.

-"Overblown growth stories": A typical feature of bubbles are overhyped growth stories – during the Dotcom bubble of the late 90s the story was that tech stocks were experiencing an "S-curve" growth (i.e. very rapid growth in the near future) and stocks were valued as options on future revenue streams which were yet to be conceived. A similar phenomenon exists today in the area of social networking, electric cars, biotechnology and the Internet (i.e. Dotcom 2.0).

-"No Valuation Anchor":Right through history, starting with the famed 17th century Dutch tulip mania, bubbles have been characterised by a lack of a valuation anchor as there is no income to provide a value benchmark. The recent Bitcoin mania – where prices rose by 5,500% in 2013 is a good example. Recent stock market favourites like Netflix, Facebook, Tesla, Twitter and even Amazon whose margins have slipped in recent years but the stock was still up 60% in 2013 as it was embraced by the growth mania.

-"Conspicuous consumption": Bubble periods also see quick fortunes, rising inequality and luxury spending booms which are all in clear evidence today. The Fed engineered boost to household wealth has benefited mainly the rich which has spurred a boom in luxury spending. The art market illustrates the speculative mood best as prices are determined purely upon what someone else would pay for it. For example, the sale of Balloon Dog (Orange) by Jeff Koons for $58 million- the highest price for a work by a living artist – for a work with five "unique" versions and which was made in a factory rather than by the artist’s own hand. The same month, a work by Francis Bacon sold for a record auction price of $142 million.

-"Ponzi Finance": Bubble periods often witness a decline in credit standards, as seen previously by subprime debt inflating housing prices. Currently, junk bond yields are the lowest in history and the quality of issuance is falling with two out of three bond issues in 2013 being junk rated, exceeding more than $1 trillion (including leveraged loans). More than half the 2013 loans came without the standard covenants to protect investors.

-"Irrational Exuberance": Valuations are the best gauge of the speculative moods. And while valuations may not have (yet) reached bubble territory, other measures of market sentiment have become very frothy. The IPO market over the last year has become very speculative, with IPOs rising by an average of 20% during the first day, but over the last six-months almost three-quarters of these IPOs were not making any profits (compared to a peak of 80% of loss making IPOs in 2000) and many did not have any revenues. Other sentiment indicators are also flashing warning signals – like the ratio of insider sales to purchases reaching record levels, a pick-up in equity mutual fund inflows, the decline in household cash balances, a near record level of margin debt to GDP and a decline in market volatility and correlation of stocks.

-GMO has constructed a sentiment index which encompasses 20 traditional sentiment indicators covering insider selling, bullish/bearish ratio of investment letters, leverage and momentum. The index is approaching two standard deviations above its long-term average (from 1950), being only exceed in 1968 and during the late 90s TMT bubble (see chart below).

– While the U.S. stock market has not reached the extreme levels prevailing during the TMT bubble – IPO issuance, first day returns, mutual funds inflows remain far below their levels in the late 90s, and private sector credit growth remains muted – the composite sentiment indicator points to poor returns going forward with expected real returns (based on historical analysis) over the next one, three and seven years being negative.

Interesting perspective and makes a good case for being cautious on the U.S. stock market. As noted in last week’s letter, while Grantham feels that the market may have another year or two to go, his sage advice is to reduce exposure over the course of this year.

On the subject of junk issuance as a percentage of total bond issuance – Professors Atif Mian and Amir Sufi had a an interesting comment in their blog: "In his speeches, ex-Fed governor Jeremy Stein cites the work of two Harvard professors, Robin Greenwood and Samuel Hanson. Their research argues that a good indicator of credit market overheating is the share of all new corporate debt issues coming from low-grade issuers (see graph below). You can see right away that this variable predicts crashes pretty well. The high yield issue share peaks about two years before major meltdowns. The high yield share in 2012 and 2013 indicates elevated risk, but not an impending disaster. For example, the 2013 high yield share is still below the peaks seen prior to other credit crashes. This may be driven in part by the fact that investment grade firms are also issuing a ton of debt. So in some sense the denominator is rising so fast that the high yield bond issues cannot keep up with it".

In the current environment, the key risk is when the Fed is likely to announce a rate hike and a reversal of its almost zero interest rate policy over the last several years. This event could cause some turbulence in asset markets, and paradoxically occur only when the U.S. economy shows signs of a sustainable and steady recovery, but that should be a temporary event as the market begins to factor in that an initial rate hike does not necessarily immediately translate into a rising rate cycle, as was the case in previous years.

As Bill Gross from Pimco noted in his recent monthly note, a 2% neutral interest rate going forward (as they expect) would not make current asset prices bubbly – just low returning. This neutral rate assumption is going to be a critical factor going forward – and currently the forward market (and the Fed committee) are factoring in a 4% rate in the years ahead. As he says: " The Great Recession occurred significantly as a result of central banks raising the price of credit too high (the Fed raised short-term rates to 5¼% in 2004/2006 as they were slowing the economy in order to moderate inflation) in the face of households and levered speculators who eventually could not afford to pay the increasing interest rate tab". Basically, a highly levered global financial system just cannot afford to have much higher rates!

Fishy Diet Does Not Promote Heart Health:

Came across a fascinating piece of research which questions the prevailing "fish is good for health" edifice.

“Fishing” for the origins of the “Eskimos and heart disease” story. Facts or wishful thinking? A review

http://www.onlinecjc.ca/article/PIIS0828282X14002372/abstract

-Diets high in fish do not promote heart heath and may increase risk of heart disease, according to a study in the Canadian Journal of Cardiology.

-During the 1970s, two Danish investigators, Bang and Dyerberg, upon being informed that the Greenland Eskimos had a low prevalence of coronary artery disease (CAD) set out to study the diet of this population.

-Bang and Dyerberg described the “Eskimo diet” as consisting of large amounts of seal and whale blubber (i.e. fats of animal origin) and suggested that this diet was a key factor in the alleged low incidence of CAD.

-This was the beginning of a proliferation of studies that focused on the cardio-protective effects of the “Eskimo diet”. In view of data, which accumulated on this topic during the past 40 years, the researchers conducted a review of published literature to examine whether mortality and morbidity due to CAD are indeed lower in Eskimo/Inuit populations compared to their Caucasian counterparts.

-The researchers conducted a review of ten different studies analyzing the diets and health of Eskimos and Inuits in Greenland and North America. They found that Eskimos in Greenland have similar rates of heart disease, an overall mortality rate twice as high, and a life expectancy 10 years shorter, compared with non-Eskimos. Inuits in North America have similar if not higher rates of heart disease, compared with non-native populations. However, the Bang and Dyerberg reports are still routinely cited as evidence for the cardio-protective effect of the “Eskimo diet”.

-What are the possible motives leading to the misinterpretation of these seminal studies? Why do so many researchers seem to uncritically quote these reports? Publications still referring

to Bang and Dyerberg’s nutritional studies as proof that Eskimos have low prevalence of CAD

represent either misinterpretation of the original findings or an example of confirmation bias.

-Recently, two meta-analyses and a well-conducted randomized controlled trial reported

ambiguous or negative results regarding the cardio-protective benefits of omega-3 fatty acids. At

the same time, nutritional guidelines in Canada, US and Europe encourage the dietary intake of

fish and omega-3 as part of a preventive approach toward CAD and overall heart-health. The

American Heart Association recommends eating fish (particularly fatty fish) at least two times

(two servings) a week.

-Although the evidence for these recommendations is unclear, it is estimated that in the US approximately 11 million adults and close to half a million children consume fish oil capsules. To date, more than 5000 papers have been published studying the alleged beneficial properties of omega-3 fatty acids not to mention the billion dollar industry producing and selling fish oil capsules based on a hypothesis that was questionable from the beginning.

-The authors conclude that an “Eskimo diet” has been misconstrued as heart healthy in the past and that such a high-fat diet is better labeled dangerous.

“Man prefers to believe what he prefers to be true.” Francis Bacon

Here’s to trying and keeping the above adage in mind always!

Regards,

Aditya

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