On Always Crying Over Spilt Milk; Work it, Flip it, Reverse it!

From: aditya rana
Date: Sat, May 14, 2016 at 2:13 PM
Subject: On Always Crying Over Spilt Milk; Work it, Flip it, Reverse it!


Jeremy Grantham put forward the proposition in 2011 that commodities – and in particular oil – could have entered a paradigm shift heralding a new era of higher prices. He was wrong and in his latest quarterly letter he analyses his mistake, draws an important lesson, and provides a prognosis of what could lie ahead for natural resources (and equity markets). To summarise:

-A successful asset allocation investment strategy rests on the foundation of diversification – provided one can avoid the busting of the rare, great bubbles.

-GMO has been able to successfully avoid the three great bubbles over the last 100 years – the US housing finance bubble of 2008, the US tech bubble of 2000 and the Japanese equity bubble of 1989 (see chart below).

-Great bubbles are easy to spot statistically, and therefore be early, at the cost of considerable career risk – perhaps losing one’s job, clients and credibility.

-Every major bull market is called a paradigm shift – i.e. the new high prices are permanent – but they almost never exist.

-In 1999 GMO had written a note analyzing 28 major past bubbles – and they had all burst. There had been no paradigm shift.

-In 2005, he had put forward the case for oil being in a paradigm shift – having spiked up over $100 in today’s prices by 1979 (see chart below) – which had odds of 1 in a billion compared to the previous trend of $16.

-This extreme outlier event was caused by a newly effective cartel (OPEC) making the paradigm shift to last as long as the cartel remained effective.

-However, after 1999 the cost of finding new oil began to rise significantly rising to about $65 a barrel currently. This rise from $16 (in today’s prices) qualified as a second paradigm shift.

-Looking at other resources in 2011, he found that the chances of iron ore reaching the then current level were 1 in 2.2 million driven by China and the growth in world population – leading him to conclude that the world could be running out of finite resources.

-Alas, he was missed the key factor of China driving higher prices rather than the world running out of resources. However, despite the current glut of supply, the price index is only two-thirds down to its old trend (see chart below) indicating that the world could be running low on some low cost resources, though the possibility of a paradigm shift is perhaps only 20%. Other factors like speculation and momentum probably account for another 20%.

-The main factor was China – constituting about 60% of the 4-sigma price rise – driven by 30 years of high growth, a late growth surge and finally the abrupt fall in growth. He totally missed the possibility of such an event (see chart below).

-As a result of the surging demand for metals from China, the miners had spent $1.25 trillion in expansion of capacity, and given the long time lags (upto seven years) new capacity will continue to increase for another two to three years.

-Assuming China grows at 4% per year for the next decade increasing its GDP by 48%, and if they bring down resource intensive investment spending to their goal of 32% of GDP from a current 47%, then the impact on increased spending on resources will be nil (i.e. 47% x 100 = 58 now, goes to 32% x 148 = 47 in 10 years).

-Therefore his positive outlook for mining resources seems to have been a major error, and a 2.2 million to 1 possibility – while rare can happen occasionally – like the land below the Japanese emperor’s palace being worth the value of California in 1989, eventually normalizing over the ensuing 26 years.

-Food, while currently being in a similar over supply glut, faces long-term intractable problems which could threaten political stability around the world. After four years of bad weather and shortages pushing up prices – an unprecedented quantity of extra land was brought into cultivation (see chart below) combined with three years of better weather, pushing down prices significantly.

-However, looking forward longer-term the factors causing a shortage of grains remain – a steady decline in productivity gains; water, erosion and pest problems; increased meat eating (being grain intensive); and global population growth (at 1.25% a year).

-Oil remains the sole candidate for being in a paradigm shift – though in the near term faces a glut caused by US fracking – because: 1) US fracking oil is a small resource being less than one and a half years of global consumption, which will soon run off causing the cost of finding new oil to begin rising again; 2) existing oil wells deplete faster than they used to because better technology pumps out more in the early years – over 5 million barrels a year ( out of 95) need to be replaced every year; 3) the large cuts in oil exploration almost guarantee another spike in the next two or three years.

-Oil prices are likely to reach $100 a barrel within the next five years, and the growing army of longer-term pessimists adds support to that view. However, beyond a 5 year recovery in oil prices lies another potential paradigm shift – the impact of electric, self driving vehicles; cheap storage of electricity; climate change and carbon taxes. This shift to alternative fuels is likely to cause another paradigm shift (downwards) in oil prices.

Investment advice:

1)Oil stocks are likely to recover over the next 5 years, but their prospects thereafter are questionable, particularly after 10 years.

2)Mineral resource stocks are unlikely to recoup their losses, but are due a bounce back from such an extreme fall, once the current excess capacity runs off over the next two years.

3)Mineral stocks also provide good portfolio diversification benefits as they are cheap compared to the market, are the only group which has a negative correlation with the rest of the portfolio over a 10-year holding period (see chart below), and have traditionally beaten the market when we experience unexpected inflation.

-Both farmland and forestry should outperform equities, with lower volatility.

-Update on equity markets:

-When markets went into a tailspin in January, the market commentary was universally very bearish and he thought it was overdone as detailed in his January letter. The subsequent bounce back has validated his relative optimism which continues based on: 1) we do not a have bubble in of the major asset classes; 2) we are not likely to end this cycle without the Fed creating an equity, or perhaps even a housing, bubble ; 3) the threshold bubble level is about 2300 on the S&P which is 10% above current levels and requires considerable more optimism amongst investors; 4) this cycle is unlikely to top out before the presidential elections and probably last a lot longer; and, 5) US housing has recovered substantially and is now 1.5-sigma above historical levels.

-However, US housing is approaching a classic echo bubble – driven partly by the view that it is still substantially below higher prices in 2006 (which were a 3-sigma event). Given the recent turmoil following the bursting of the housing bubble in 2008, it would seem psychologically difficult to enter into another housing bubble – but as the chart below illustrates, if the pace of price increases continues we could be at the 1.75 sigma event by the summer. So over the next 12 to 24 months US housing might actually beat US equities to qualify as a bubble (with housing being a more dangerous bubble as well).

-Meanwhile, equities are likely to continue being generally overpriced as they have been most of the time since the Greenspan policy of pushing down short-term rates. A 60% equities/40% bonds portfolio is unlikely to deliver more than 3% return, and most institutional investors are going to find it impossible to achieve targets of 5%, let alone 7%.

-However, investors are likely to continue being invested – justifying the extra risk on account of seeking higher returns. This is dangerous as “the market does not care about your targets!” but prices are likely to become even more over-priced over the next few years and investors should then guard against throwing in the towel – like many did in 1999!

Another masterful quarterly from Grantham, highlighting the danger of thinking “this time is different” which even the great investors sometimes fall prey to! Given the continued support from central banks, it makes sense to stay invested in a diversified manner, weighted towards relatively undervalued assets like EM equities (and China).

-On China, attached below is an interesting chart on the broad (including offshore listings) Chinese stock market over the last two decades. Some key features stand out:

-The Chinese market has experienced large gains and downdrafts – being driven by retail investors and their perceptions on shifts in government policy.

-The 65% fall in 2007-2008 was preceded by a 7.5 times rise over 5 years. The 30% fall over the last year was preceded by a relatively muted rise of 1.8 times over 5 years.

-The broad Chinese stock market has compounded by 2.6% per annum (in $s) over the last two decades, while GDP has compounded by about 10% per annum. As other stock markets (including the US) have demonstrated over history– earnings/GDP and stock market cycles are usually not in sync over multiple years- but over the longer term they do tend to converge. Ironically , the expected GDP slowdown over the ensuing decade is likely to herald a period of superior stock market returns.

Work it, flip it, reverse it!

Yet another great note from Dr. David Katz, Director of Yale University Prevention Research Centre, on a useful and simple method to analyse new diet studies making headlines and to help you draw your own conclusions:

HuffPost May 9, 2016:

-The song lyrics: work it; flip it; reverse it, pertain beautifully to diet study outcomes, and what those serving their established self-interests and prefabricated conclusions are prone to tell you they mean. I have two illustrations for you, and then a general conclusion.

-The first, and more recent of the two is the study that allegedly told us vegetable oil is bad for us now. I have cited the study, and addressed it in some detail before, so I’ll keep this at a rather high level. In brief, the article examined data from 50 years ago, and found no obvious, short-term benefit of very high-dose corn oil over saturated fat among the very small percentage of trial participants who stuck with the program for a year.

Again, it’s not my intent here to get into the particulars of methodologic merits, or demerits. I’ve already done so, and others have as well, more thoroughly than I. Let’s just stick with the outcome.

-On the one hand, the study — at least superficially — does say that high-dose corn oil is not “better” than saturated fat. The camp currently advocating for more meat, butter, cheese; and telling us that saturated fat is “good” for us now has, predictably, embraced that message. But just a moment, now. Work it; flip it; reverse it.

-If there was no discernible heart disease difference between those chugging corn oil, and those consuming more saturated fat — it says, just as plainly, that saturated fat is not “better” than high-dose corn oil. The very same “eat more saturated fat” camp tends to make a lot of noise about the harms of vegetable oil. Some simply argue that vegetable oils, not animal fats, have been our real problem all along. Others dive deeper to talk about omega-6 fats, and their pro-inflammatory effects.

-But those details don’t matter. It gets very simple, very quickly, once you work it a bit. If this study is invoked because of what it shows about dietary fat and heart disease, then you have to make a choice. If saturated fat is “good” for us, so is high-dose corn oil — because the outcomes were the same. If high dose corn oil is “bad” for us, then so is saturated fat — because the outcomes were the same. The conclusion being promulgated, in other words, is not about the data, or epidemiology — it’s just about ideology.

-If you work it just a bit, it’s unavoidable that you flip it, and reverse it. If this study is an argument “for” saturated fat, it’s an argument for high-dose corn oil. If it’s an argument “against” high-dose corn oil, it’s an argument against saturated fat. Frankly, I don’t think it’s either — both because of the nature of the study, and because these polarized, either/or, my-way-or-the-highway proclamations about nutrition tend to be self-serving nonsense. Excessive saturated fat from the usual dietary sources remains harmful. So, too, is an extreme imbalance in unsaturated fats, whether the product of chugging corn oil, or simply eating the typical, and lamentable, American diet.

-The second illustration is an older vintage, although the message of it remains timely. When a meta-analysis came out in 2014 finding that heart disease rates were effectively the same for those in the top, and those in the bottom tertile of saturated fat intake, members of the church of latter day saturated fat canonizers were again quick to pounce. We were told, in various prominent fora, that here was proof we had been wrong all along about saturated fat, and — the real problem was sugar.

-But, again, let’s work it. This 2014 meta-analysis was the successor to a prior,2010 meta-analysis that had shown much the same. Intriguingly, and maybe even inscrutably, the 2014 meta-analysis did not address what was replacing saturated fat calories, even though this was the final line of the abstract of the earlier paper on the same topic: More data are needed to elucidate whether CVD risks are likely to be influenced by the specific nutrients used to replace saturated fat.

-In any event, I was pretty sure I knew, back in 2014, what had replaced saturated fat calories when they went down. We know that Americans aren’t eating more broccoli. Our misguided forays into “cutting fat” translated, through a combination of demand-side naïveté and predatory profiteering on the supply side, into Snackwells, donuts, and multi-colored marshmallows masquerading as “cereal.” If that conjecture on my part was right — that lower saturated fat intake meant higher sugar intake, and vice versa — then this study was suggesting that each was exactly as bad as the other.

-My impression resided in the realm of speculation only very temporarily. Researchers at Harvard took on the mantle of the “instead of what?” question with which the 2010 meta-analysis concluded. Their findings, published in 2015 in the Journal of the American College of Cardiology affirmed my intuition on the topic, but more importantly, the predictable conclusions to anyone with a valid, working knowledge of nutrition. When saturated fat calories were replaced by trans fat calories, things went from bad to worse. When replaced by sugar and refined starch, they remained comparably bad. When replaced by either unsaturated oils from their customary sources (e.g., nuts, seeds, olives, avocado, fish), or by whole grain calories- heart disease rates declined markedly.

-So, that 2014 meta-analysis did, indeed, suggest that saturated fat was not appreciably worse for us than what was replacing it — namely, sugar and refined starch. But it showed with exactly comparable clarity that saturated fat was no better for us, either, since heart disease rates were the same at both ends of the scale. You don’t have to work the “saturated fat is not the problem since it’s no worse than the alternative” conclusion very hard to flip it, and reverse it: it’s no better, either.

-Studies suggest that an excess of saturated fats mostly from animal sources are about as bad for us as a massive imbalance in unsaturated fats from plant sources. Studies suggest that health suffers commensurately from an excess of saturated fat, or an excess of sugar. Science and sense alike suggest that the way to fix this is not to choose one nutrient nemesis over another, but to eat a diet of wholesome foods, mostly plants, in a sensible and time-honoured assembly, and get all the nutrients right.

Here’s to staying away from the latest dietary fads and sticking with time-honoured principles of health eating – eat whole food, in limited quantities, and mostly plants!




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