On Grantham’s Wisdom; The China Corrrection; Eggs and Heart Disease!

From: aditya rana
Date: Sat, Jul 4, 2015 at 1:26 PM
Subject: On Grantham’s Wisdom; The China Corrrection; Eggs and Heart Disease!


Jeremy Grantham, co-founder of the famed value investment firm GMO, recently gave an interview which touches on a broad variety of subjects – not least the likely trend for the U.S. stock market over the coming year. Grantham writes a quarterly newsletter which is a must read for serious value investors, and are typically replete with deep insights into the investing process as well as broader topics covering the nature of bubbles, long term growth trends, commodities, investor psychology and the depletion of natural resources. This interview touches on most of the above topics – to summarise:

-The U.S. stock market is heading higher, at least until the 2016 elections, and is likely to breach the “two-sigma” threshold which defines bubble territory. At some subsequent point a “trigger” will precipitate a move back to mean trend levels.

-The major reasons behind this are the post-Bernanke Fed stimulative policy and a “stock-option culture” which has elevated corporate margins and reduced capital investment which is required for the long term health of the economy.

-The market is driven by career risk, with investors primary motivation being to keep their jobs – in the words of Maynard Keynes “never be wrong on your own, and if you are going to be wrong, make sure you have plenty of company”. This phenomenon leads to an investor herd mentality which drives asset valuation far beyond fair value.

-Their current 7-year forecast estimates a 2.3% per annum real return for U.S. large cap stocks and earnings growth to mean-revert to 5.7% real annually. For equity returns to increase to historical levels, P/E ratios would need to fall by 37%, and profit margins would need to reduce by 30%. GMO forecasts in recent years have been less accurate than previously due to the intervention of Fed policy. They have been early before – in particular during the period preceding the dot-com crash of 2000, but they timed the 2008 crash more accurately.

-The Fed’s policy has helped drive high margins, a stock-option culture and a fixation on short-term results. P/E ratios are now 60% higher than over the previous 100 years, and profit margins are 40% higher than the Greenspan era – averaging 8.4% versus a level of 5.9% previously.

-The prevalence of the stock-option culture has led to 80% of management compensation linked to stock options, versus 20% 30 years ago. During the 1960s through to the 1980s, corporates focused on market share which led to higher capital spending, job creation and wage growth, but adversely affected profits. However, since the 1980s, corporations have chosen the much less risky path of stock buybacks (when compared to investment) to drive valuations and profitability. Stock buybacks have accelerated dramatically averaging $700 billion annually, while capital spending is 4% below average, even after a 6-year recovery with record profits margins.

-The lack of capital spending has acted as a drag on economic growth, while making senior management rich who are focused on stock-buybacks to push up stock prices and thereby increasing the value of their stock options.

-Their team at GMO have identified 28 major bubbles (defined as a two standard deviation move above its historical mean) through history, and each one of them has eventually burst. This demolishes the Fama-French market efficiency theory , and demonstrates the craziness of investors.

-Government interference is usually a root cause in the creation of bubbles – for example, the housing booms in the U.K. and Sydney were promoted due to policies which allowed immigration but at the same time prevented housing investment due to zoning restrictions at the local level – resulting in a bubble in both markets. In the U.S., Ireland and Spain, the central bank low rate policy facilitated excessive housing construction leading to bubbles in all three cases.

-The current stock market boom in the U.S. has also been created by the Fed with artificially low rates, making it very appealing for corporations to borrow cheap and buy back their own stock. This activity is not expanding the economy and should be corrected by regulation or growth will continue to suffer.

-Currently, the stock market is at the 1.5 sigma level, and is unlikely to correct until it breaks the 2-sigma level. The election could be a potential trigger for the correction.

-While the overvaluations in stocks, bonds and fine art are all classic sign of a bubble, there needs to be a trigger to break the bubble – and we have to wait until individuals become crazy buyers and acquisition deals become more frenzied. He does not think the Fed rate hike will be a trigger.

-The moral hazard created by the Fed led economy based on the notion that “in a bull market you are on your own, and in a bear market the Fed will come to the rescue” has led to long seven-year bull markets followed by 18 month bear markets, which provides further support for the stock-option culture – “when prices rise you make a fortune and when they crash you rewrite the options”.

Deep insights into financial markets and the causes of bubbles, and how one might participate in a Fed led market – stay long as long as the Fed has a supportive policy and start reducing exposure once we start approaching bubble territory – particularly if a change in the political regime takes place which might constraint the Fed’s accommodative role. Current market sentiment is negative (as the chart below shows) which does support the case for a continued rally in stock markets.

On the China correction:

-Regarding the 29% fall in the Shanghai index over the last three weeks, it is important not to lose sight of the fact that the market is still up 79% over the last year (we are close to the anniversary of the date in late July when the bull market commenced, triggered by the implementation of the Yuan 1 trillion lending scheme dubbed “QE-lite” by the PBOC and further bolstered by the rate cut in November, 2014) making it the world’s best performing market by far. Even on a YTD basis the market is up 14%, which puts it amongst the best performing global stock markets (the others being Italy, Russia, Japan, and Germany in that order).

-The trigger for the sell-off three weeks ago were regulatory steps taken to clamp-down on the unofficial margin lending for stock purchases estimated to be Yuan 500 million (and possibly as high as 1 trillion) in contrast to the official margin lending of Yuan 2.1 trillion ($350 billion). Specifically, on June 13 (the market started its correction on June 15) the regulator asked brokerage companies not co-operate with companies engaging in “peizi” or “fund-matching” schemes which effectively provide margin to anyone who wants it and skirts the official restrictions. This follows the clamp-down (mid-April) on brokerage companies to work with umbrella trusts which have been another avenue to provide extra leverage to investors (through a CDO type tranched scheme). The unofficial channels provide leverage of upto 5x versus the upto 2x provided by the official margin lending facilities, making the unwind triggers higher for the unregulated channels than the regulated margin triggers (which are estimated to be still 30% below the current market (at an index level of 2,500). While this action might have had unintended consequences in terms of the market rout, it is a move in the right direction to make the stock market healthier over the longer term.

-Going forward, government action to support the market and turn sentiment around are likely to be key and they could include the following measures: get affiliated funds such as Huijin and the pension fund to buy, CSRC may suspend IPOs (they announced yesterday evening a plan to restrict the amount of new IPOs which have been a key factor in soaking up retail funds with the 70% increase in size over the last year), insurance companies may be encouraged to enter into the market, MoF may cut stamp duty on stock transactions, and PBoC may announce more easing measures, among other possibilities. It was government policy which triggered the sell-off and it will be further policy action which will stem further falls (much like any other stock market around the world!).

What course of action to take in this market? Investing in Chinese stocks is clearly not for the faint-hearted! Following the Interim top in Chinese stocks call in the newsletter dated June 6 (as suggested by the technical firm EWI which expects the correction to last a few more months), investors who might have trimmed their exposures then could consider gradually adding back exposure – particularly in the large-cap stocks on the Shanghai exchange (the A-50 index accessed via ETFs 2823 and 2822 listed in Hong Kong) which are now trading at attractive valuations. As suggested in last week’s newsletter, investors who are long-term bullish on the Chinese stock market should use this correction as an opportunity to gradually add exposure at cheaper levels.

-As the research firm 13 D (having been involved in the Chinese stock market since its inception in 1992) says : “There is no bull market like a Chinese stock bull market”.

Eggs Increase Risk for Heart Disease

PRCM, July, 2015:


-Egg consumption may increase the risk for heart disease, according to a study published in Atherosclerosis. Researchers monitored the diets of 23,417 South Korean participants through the Kangbuk Samsung Health Study and found that heart disease risk increased incrementally with increased egg intake. Those who ate the most eggs, compared with those who ate the least, had 80 percent higher coronary artery calcium scores, a measure of heart disease risk.

– The association was particularly pronounced among individuals with low vegetable intake and those with high BMI. Eggs also appeared to increase the risk for obesity, diabetes, and hypertension.

I will be travelling for the next two weeks and the newsletters will recommence on July 25. Wishing my readers an enjoyable summer!




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