Investing in liquidity driven markets

Today’s commentary

I have spent some time this past weekend reading what investment manager Hugh Hendry has had to say about why he has turned bullish. And the clear takeaways are twofold. First, it is very difficult to ‘fight the Fed’ when it wants growth. Second, the reflexive pursuit of growth leads to liquidity driven markets and that’s bullish for shares in the short- and medium-term. Where this leads over the longer-term is another matter.

There has been a lot of hubbub around the recent Hendry monthly newsletter in which he professes to having turned tactically bullish. He starts out provocatively, asking “What if I were to tell you I was turning more bullish? Is that something you might be interested in?” And then Hendry goes on to tell us why he has become bullish. The gist here is that as a fund manager, missing a bull market is a dismissible offense. Funds like Hendry’s have underperformed massively while the market has been vaulting higher. How do you reconcile this underperformance with the 2 and 20% fee arrangement you have as a hedge fund? It’s difficult.

We have heard the same concerns from other value-oriented investment managers. They tell us the market is overvalued and tell us how they intend to invest, cognizant that the expected market returns should be lower given that markets eventually revert to mean.

Bill Gross, for example, has the same problem in bond markets. He starts off having to defend active management given the low fees and good performance of the indexing approach championed by the likes of Jack Bogle. The question, again, is how do you justify the fees? Gross writes that:

for almost all measurable asset classes, index funds and many ETFs have done a better job than almost all active managers primarily because of lower fees.

The ‘almost all’ caveat is the reason I can write so freely and with such high praise for Vanguard. I am, after all, supposed to be promoting Pimco in these Investment Outlooks, and Pimco is a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what he labelled in a recent Morningstar interview the “Pimco effect.”

To paraphrase his interview, he spoke to index managers beating almost all active managers, but then “there was the Pimco effect”. We at Pimco thank him for that with a “back ‘atcha, Jack!” There’s actually a place for both of our firms and investment philosophies in this age of high finance.

Then Gross goes on to say that there is room for different investment types, especially given the fact that markets tumble! You don’t want to be passively invested when markets are falling, do you? But how does an active manager like Gross deal with a market that is vaulting higher than he feels comfortable with? Gross says, “De-risk while the price is wrong”.

Then there’s Jeremy Grantham and GMO. He is the source of my comment about missing a bull market being a dismissible offense. He also sees markets becoming increasingly detached from the fundamentals. His colleague Ben Inker calls US equities 40% overvalued. Inker expects a negative return over the next seven years. What does Grantham say then? The same thing as Gross:

“In the meantime investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years – and that most foreign markets having moved up rapidly this summer are also overpriced but less so. In our view, prudent investors should already be reducing their equity bets and their risk level in general. One of the more painful lessons in investing is that the prudent investor (or “value investor” if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve. “

Conclusion: Don’t wait until prices are collapsing to de-risk because it will be too late then. That makes sense but the problem of course is that if you get caught out as a cautious investor as the market rose to begin with, you are already ‘de-risked’. That’s where Hendry is and that is why he is un-de-risking – tactically, of course.

Why is this even happening? I believe the main reason we are seeing such extreme levels of all-asset class overvaluation is that central banks want growth – and they can only get that growth by transmitting policy through the financial sector and asset price inflation, leverage and credit growth. This is exactly what monetary policy is all about. The limits of monetary policy, as I have espoused them, are simply not recognized.

This weekend I also ran across an interesting Wikipedia entry on Keynesian revivalism that I think is very related here. The way I came across this piece is interesting. I was going through my RSS feed and came across two articles from Die Welt, a German newspaper, in which Economics Nobel Prize Winner Edmund Phelps was extolling Switzerland, lambasting Germany and expounding on his own personal political philosophy of economics (link in German). Phelps sees corporatism as a big problem – as do I – and this has led him away from ‘crude Keynesianism’.

When you look up Phelps in Wikipedia, there is a link in his entry to “Keynesian resurgence”, an entry that has an important part which reads as follows:

The stagflation of the 1970s, including Richard Nixon’s imposition of wage and price controls on August 15, 1971, and in 1972 unilaterally canceling the Bretton Woods system and ceasing the direct convertibility of the United States dollar to gold, as well as the 1973 oil crisis and the recession that followed, unleashed a swelling tide of criticism for Keynesian economics, most notably from Milton Friedman, a leading figure of monetarism, and the Austrian School’s Friedrich von Hayek.

In 1976, Robert Lucas of the Chicago school of economics introduced the Lucas critique, which called into question the logic behind Keynesian macroeconomic policy making and leading to New classical macroeconomics. By the mid-1970s policy makers were already beginning to lose their confidence in the effectiveness of government intervention in the economy. In 1976 British Prime Minister James Callahan went on record saying the option of “spending our way out of recession” no longer exists. In 1979, the election of Margaret Thatcher as UK prime minister brought monetarism to British economic policy. In the US, the Federal Reserve under Paul Volcker adopted similar policies of monetary tightening in order to squeeze inflation out of the system.

In the world of practical policy-making as opposed to economics as an academic discipline, the monetarist experiments in both the US and the UK in the early 1980s were the pinnacle of anti-Keynesian and the rise of Perfect Competition influence. The strong form of monetarism being tested at this time taught that fiscal policy is of no effect, and that monetary policy should purely try to target the money supply with a view to controlling inflation, without trying to target real interest rates; this was in contrast to the Keynesian view that monetary policy should target interest rates, which it held could influence unemployment.

Monetarism succeeded in bringing down inflation, but at the cost of unemployment rates in excess of 10%, causing the deepest recession seen in those countries since the end of the Great Depression and severe debt crises in the developing world. Contrary to monetarist predictions, the relationship between the money supply and the price level proved unreliable in the short- to medium-term. Another monetarist prediction not borne out in practice was that the velocity of money did not remain constant, in fact it dropped sharply

Sound familiar? This is what I have described. I think this is a really good Wikipedia entry because it details the historical context well and also points to how fiscal policy was whipped out as a last resort during the depths of the crisis but how monetary policy really remains the only game in town. It’s not that I am advocating ‘crude Keynesianism’, though. There is the spectre of corporatism, which is very real. But, let’s remember what the asset-based model does. 

So, it goes like this then:

1. When the economy flags, policy makers have to decide whether to intervene or let things play out.
2. If the economy flags enough, policy makers will always intervene to prop up economic growth.
3. But there is a general distrust of government intervention. 
4. Somehow the central bank’s independence makes it seem like cutting rates isn’t government intervention.
5. So, because of the ideological aversion to fiscal intervention, only monetary intervention is used to prop up the economy.
6. The result is an asset-based economic model that fosters credit growth, leverage, asset price inflation, and eventually bubbles.

I will give you a real world example of what I mean.

Jim Pietrocini has joined the jumbo adjustable-rate mortgage party.

In early December, he refinanced his 4,600-square-foot Carlsbad, California, home that overlooks the Pacific Ocean. Pietrocini, a computer software consultant, couldn’t resist the deal on the jumbo, a loan exceeding the limit the government will buy. His $744,000 mortgage at 3.5 percent, which adjusts annually after seven years, will save him almost $8,000 a year compared with a fixed rate loan at 5 percent.

 […]

A decade ago, jumbo ARMs helped fuel the housing bubble by letting buyers qualify for homes they only could afford at the low rates before they reset. Banks approved mortgages based on the assumption that house prices would keep rising and the loans could be refinanced before higher costs kicked in.

When home prices stopped climbing in mid-2006, both jumbo and conventional ARM borrowers began defaulting in higher numbers, contributing to the collapse of the mortgage market that in turn led to the most severe financial crisis in decades.

“People have decided that whatever happened in 2008 is not going to happen again,” said Richard Lepre, a San Francisco-based loan officer with RPM Mortgage Inc. “There is not much concern about home values falling again. There is more concern about bank borrowing costs going up.”

 So how does this end? I think this ends badly. It ends with bubbles, a crash and low future returns. In the meantime, you have to invest in a way that keeps you employed but also gets you the best returns over the long term. That is very difficult to do in liquidity driven markets.