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GMO QUARTERLY LETTER October 2010 Jeremy Grantham NNIGHT OF THE LIVING FED Something unbelievably terrifying omee Runaway nnks co e! Homes Commodities ! Ba kttolif C bback Destroyed ! Curree w a ncyy FFamilies rss! Evicted ! StarrBEN BERNANKE and IntrodJANET YELLEN with Guest Appearance as Chief ZombieN ALAN GREENSPAN The Ruinous Cost of Fed ManI would limit its activities to making sure that the economy My diatribe against the FedFurther, I would force it to swear off manipulating asset make it easier to follow, a summary precedes the longernd asymmetric argument. (For an earlier attack on the Fed, see “Feet ofs – the Greenspan/Bernanke Clay” in my 3Q 2002 Quarterly Letter.)ld be a better, simpler, and less dangerous Purpose world, although one much less exciting for us students If I were a benevolent dictator, I would strip the Fed of itscurrent policy can we obligation to worry about the economy and ask it to limitess by 2014: Bernanke’s its meddling to aﬂation. Better yet, ined reappointment hearing. To Summarize dotcom and ﬁber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007. 1) Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates. 11) Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more 2) Therefore, lowering rates to encourage more debt is easily borrowed against, and seen as a more stable useless at the second derivative level. asset. Consequently, the wealth effect is greater. 3) Lower rates, however, certainly do encourage 12)More importantly, house prices, unlike equities, speculation in markets and produce higher-priced have a direct effect on the economy by stimulating and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people, prices mislead consumers and budgets alike. not counting the associated stimulus from housing- 4) Our new Presidential Cycle data also shows no related purchases. measurable economic beneﬁts in Year 3, yet point to 13) This increment of employment probably masked a a striking market and speculative stock effect. This structural increase in unemployment between 2002 effect goes back to FDR, and is felt all around the world. and 2007, which was likely caused by global trade developments. With the housing bust, construction 5) It seems certain that the Fed is aware that low rates fell below normal and revealed this large increment in and moral hazard encourage higher asset prices and structural unemployment. Since these particular jobs increased speculation, and that higher asset prices may not come back, even in 10 years, this problem have a beneﬁcial short-term impact on the economy, may call for retraining or special incentives. mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of 14) Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have monetary policy on the economy are negligible. negative house equity. The lesson here is: Do not 6) It seems certain that the Fed uses this type of stimulus mess with housing! to help the recovery from even mild recessions, which 15) Lower rates always transfer wealth from retirees might be healthier in the long-term for the economy (debt owners) to corporations (debt for expansion, to accept. theoretically) and the ﬁnancial industry. This time, 7) The Fed, both now and under Greenspan, expressed there are more retirees and the pain is greater, and no concern with the later stages of investment bubbles. corporations are notably avoiding capital spending This sets up a much-increased probability of bubbles and, therefore, the bene ﬁts are reduced. It is likely forming and breaking, always dangerous events. that there is no net beneﬁt to artiﬁcially low rates. Even as much of the rest of the world expresses 16) Quantitative easing is likely to turn out to be an even concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?) more desperate maneuver than the typical low rate policy. Importantly, by increasing in ﬂation fears, 8) The economic stimulus of higher asset prices, mild in this easing has sent the dollar down and commodity the case of stocks and intense in the case of houses, prices up. is in any case all given back with interest as bubbles 17) Weakening the dollar and being seen as certain to do break and even overcorrect, causing intenseﬁnancial that increases the chances of currency friction, which and economic pain. could spiral out of control. 9) Persistently over-stimulated asset prices seduce states,18) In almost every respect, adhering to a policy of low municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences and have causedﬁnancial crises as asset prices revert of bubbles breaking, and displaying a complete back to replacement cost or below. refusal to learn from experience has left Fed policy 10) Artiﬁially high asset prices also encourage as a large net negative to the production of a healthy, misallocation of resources, as epitomized in the stable economy with strong employment. GMO 2 Quarterly Letter – Night of Living Fed – October 2010 The Effect of Debt on Long-term Growth between debt and GDP growth. After all, the last 10 to 15 years have revealed some great reasons for GDP growth My heretical view is that debt doesn’t matter allto be stronger than average, not weaker: the growth rate much to long-term growth rates. What I owe you, aof emerging countries helped along by the collapse of you owe Fred, and Fred owes me is not very important; communism and the moderate de-bureaucratization of on the positive side, all it can do is move demanIndia, the ensuing explosion of world trade, and a claimed a few weeks and then give it back later. This is surge in productivity from the rapid developments of the world. It is, in an important sense, not the real world. In the real world, growth depends on real factors: thenet and cell phone technology in particular. Given the above, there is little or no room for higher debt levels quality and quantity of education, work ethic, poto provide a net bene ﬁt to economic growth. Therefore, proﬁle, the quality and quantity of existing planartiﬁcially low interest rates must also be of insigni ﬁcant equipment, business organization, the quality of public help to long-term growth, for its main role in stimulating leadership (especially from the Fed in the U.S.),growth is to encourage more debt. After all, a lower rate the quality (not quantity) of existing regulationhurts the lenders exactly as much as it helps the borrowers. degree of enforcement. If you really want to worrThe debt expansion, though, was great foﬁnancial growth, you should be concerned about sliding eduindustry proﬁts: more debt instruments to put together, to standards and an aging population. All of the reasell, and to maintain. Not to mention all of those debt of debt is negative: it can gum up the works in a liquidity/pay for and charge for, and all of that increased solvency crisis and freeze the economy for quite a while. investment managers to manage. Thus, the role of ﬁnance grew far beyond its point of usefulness. (See On this topic, take another look at Exhibit 1, my“Finance Goes Rogue” in last quarter’s Letter.) favorite. What a powerful and noble experiment! We tripled debt to GDP ratio over 28 years, and yet GDP growth slowed! And it slowed increasingly, especiallyEffect of Subsidized Rates and the Economy on Financial Markets after 2000. The 3.4% trend line had been intact for over 100 years, from 1880 to 1982. From this data it is possibleized debt – debt at manipulated rates – in to hope that the decline in GDP would have been eventrast to normal debt at market clearing prices, has a worse if we had not been wallowing in debt. But I believerofound, and dangerously distorting effect on it probably suggests that there is no long-term connectionices. The Presidential Cycle, which I have often Exhibit 1 Debt Does Not Create Growth! 400% 16.0 Stable Debt Era Rising Debt Era 350% 15.5 per Year +2.4% Log of Real GDP 300% GD P 15.0 a r 250% erYe 14.5 3.% p D P + 200% G 14.0 Total Debt Total Debt as a Percentage of GDP 13.5 100% 13.0 Dec-52 57 62 67 72 77 82 87 92 97 02 07 Source: Federal Reserve Flow of Funds, GlobAs of 6/30/08Data Quarterly Letter – Night of Living Fed – October 2310 GMO talked about, shows most clearly how hard it is to move of the market even more. Exhibit 3 reminds us of the the real economy with low rates and moral hazard, and substantial Fed effect all around the world. Never ﬁght how easy it is to inﬂuence speculation and market prices. the Fed about market prices or underestimate its global Table 1 shows the data for growth in GDP and employment reach. The U.K. stock market has been more responsive in Year 3 of the Cycle: it is completely normal, not above to the U.S.’s Year 3 stimulus than the U.S. market has average at all. itself. It shows Britain in its true colors: half a hedge fund and half the 51 state. How humiliating! The economic response to the extra market move of 18.5% in Year 3 occurs in Year 4, just when it is needed politicaGreenspan and Bernanke Learn How to Stimulate It shows a reasonable 0.6% increase in GDP, a 0.5% gain in consumption, and a 0.3% drop in unemployment. This Stock Markets last item, by the way, is the only thing we have ever Here the plot thickens, for I suspect that Greenspan and found that actually moves the vote. This 0.6% effect for Bernanke know this: that their only decent tool to help the economy is to move the market. They know, as we have also GDP, though, is almost exactly what could be expected from the wealth effect on its own, leaving no room in the deduced, that the market is far more sensitive to monetary data for Fed stimulus (or ﬁscal stimulus, for that matter) factors than is the real economy. “Monetary policy works to have had any other economic effect in Year 4. This for the most part by in ﬂuencing the prices and yields of can be tested by looking at all of the best 12-month ﬁnancial assets, which in turn affect economic decisions and thus the evolution of the economy” (Bernanke, May market moves, excluding Year 3s, which have a cut-off just 3.5 percentage points per year better than the Year 3 2004, American Economic Review). If you believe this, performance (22% versus 18.5% above average). These then goosing the market deliberately is a useful short- moves are followed by an extra 0.8% GDP the following term tool for getting traction in difﬁcult economic times, year – a very similar relationship to that between Years such as those following a severe ﬁnancial crash or even a 3 and 4. It is reasonable to conclude from this data that normal cyclical contraction. the Fed was able to move the market a lot in Year 3, but that the wealth effect associated with these moves was the Unfortunately for us, as the economy recovers and the artiﬁcially stimulated market gets up a nice head of steam, only effect on fundamental growth. As a footnote, we can the Greenspan-Bernanke team of ﬁcially loses interest, conclude that the stock market wealth effect here works out to about 3% of increased wealth, which is compatible emphatically and repeatedly denying any interest in, or responsibility for, curtailing their latest experiment in with most academic studies. (Please note that this 3% number includes one cycle of house price wealth effect market manipulation. And manipulation is exactly what it is. They express uncertainty that a bubble could even over the 50 years, and so is moderately overstated.) exist. Who am I, argued Greenspan, to disagree with In contrast, Exhibit 2 reminds us of the remarkably large the opinions “of tens of thousands of well informed effect that low rates and the Greenspan-Bernanke put have investors?” They both imply or state outright that on speculation in Year 3, both in raising the broad market markets are overwhelmingly efﬁcient, yet they themselves and, not surprisingly, on lifting the speculative quarter manipulate the prices to help in the recovery from a Table 1 Presidential Cycle Effects on Real Economy: None in Year 3, Some in Year 4 The Year 3 Effect Moves Market but not Economy Year 3 Stock Moves Affect Year 4 Economy Year 3 Compared to Average Year 4 Compared to Average Average Change in Unemployment +0.15% Average Change in Unemployment -0.26% Average Real GDP Growth -0.3% Average Real GDP Growth +0.6 % Average Real Personal Consumption Growth -0.2% Average Real Personal Consumption Growth +0.5 % Average Stock Market Real Return +17.6 Average Stock Market Real Return +1.7 % % Average Change in Fed Funds -0.56% Average Change in Fed Funds +0.26 % Source: S&P, BLS, Federal ReserData from 1/1/64 to 12/31/07 GMO Quarterly Letter – Night of Living Fed – October 2010 4 Exhibit 2 WOW … (It's Year 3 Market Moves that Affect Year 4 Economy) Presidential Cycle 1964-2007 4 r a e 3 Y r a e 2 Y r a e 1 Y r Exhibit 3 Never Underestimate the Fed’s Global Reach! Third year of local markets relative to their average: 1964-2010 recession! How are we to interpret these contradictions? As distortions of their true beliefs, or as sloppy thinking revealed? Whichever it is, we have discovered twice in a decade, and may discover again in a year or two, that this Quarterly Letter – Night of Living Fed – October 2010 economy with two possible exceptions – runaway iﬂ nation House prices may often not be susceptible to manipulation. and a housing bubble. So, not only have these two Fed Low interest rates may not be enough: they may stimulate bosses been almost criminally inept in ignoring stock hedge fund managers to speculate in stocks, but most bubbles, they have also deliberately instigated them as a ordinary homeowners are not interested in speculating. policy tool! Since we continue to be at Bernanke’s mercy To stir up enough speculators to move house prices, we and Greenspan’s spirit is still alive and well, could things needed a series of changes, starting with increasing the be much worse? percentage of the population that could buy a house. This took ingenuity on two fronts: overstating income and Messing with Housing Is More Dangerous than Messing with Stocks reducing down payment requirements, ideally to nil. This took extremely sloppy loan standards and virtually no Well, yes, they could be worse. For the same technique that data veriﬁcation. This, in turn, took a warped incentive program that offered great rewards for quantity rather encourages equity markets (and especially speculation) also encourages housing prices. The housing market is than quality, and a corporation overeager, with aggressive much, much more dangerous to mess with than stocks, as is accounting, to book pro ﬁts immediately. It also needed clearly illustrated by the Greenspan-instigated remarkable a much larger, and therefore new, market in which to place these low-grade mortgages. This took ingenious and disastrous housing bubble of 2002-06. Housing is always likely to have a larger effect on consumption than new packages and tranches that made checking the stocks for many reasons: for one, higher house prices used details nearly impossible, even if one wanted to. It took, to feel permanent, while those for stocks were uncertain. critically, the Fed Manipulated Prices to drive global rates Borrowing against house values has always been more down. Even more importantly, it needed the global risk appealing for other reasons: it is easier and usually premium for everything to hit world record low levels so cheaper to withdraw equity or increase leverage, and is that suddenly formerly staid European, and even Asian, institutions were reaching for risk to get a few basis points not subject to margin calls. This housing cycle, of course, was exceptional in that borrowing against increased more interest. Such an environment is possible only if house values was rendered effortless and was actively there exists an institution with a truly global reach and encouraged by parts of the ﬁnancial industry. The latter a commitment to drive asset prices up. In the U.S. Fed, under the Greenspan-Bernanke regime, just such an was done with such “success” that at the very peak of the ﬁrst-ever housing bubble in the U.S., with prices up 60% institution was ready and willing. in four years and 100% in seven years, borrowing against house values reached a record 50% of the total new ﬂiated The Wealth Effect of Housing value. Rising house prices were initially a potent boost to The effects of house price increases on consumption have the economy, but later became a lethal weapon. It was been hard to measure. First, prior to 2000, nationwide just possible that the housing bubble was incidental to house prices had never risen materially, so there is no good the deliberate attempt by Greenspan to encourage higher historical data. Second, if such a rise stimulates a surge in stock prices, and it may have been unexpected, but the home building and an accelerated turnover of houses, it is evidence suggests otherwise. As early as 2001, Greenspan impossible to separate this direct stimulus from the wealth was practically bragging about the help that rising house effect. But based on a sample of one in the U.S. and a few prices was delivering to the wounded economy. Yet, to overseas, we can conclude that the stimulus effect from a further confuse the issues, while Greenspan later began house price rise is somewhat greater than for stocks if the to see “extreme speculation” in some housing markets, boom is not accompanied by a house building surge (as Bernanke remained unconvinced, claiming not to see a in the U.K. andAustralia), and far greater if there is such problem even as house prices in 2006 hit the 100-year a surge (as in Ireland, Spain, and the U.S.). The direct ﬂood level. “It largely reﬂects the strong U.S. economy.” effect for stocks and houses is usually calculated as being That was it. And, after all, not to worry, for “U.S. house between 2.5% and 5%, meaning that up to 5% of the new prices have never declined.” Thus, with a closed mind, wealth is used for increased spending in the next several he seemed to completely ignore the extreme sensitivity of years. (Our research suggests the lower end of the range.) the economy to housing, and this mistake brought us, and The increased facilities to withdraw capital from housing most of the developed world, to our knees. It was a direct in the U.S. almost certainly made it a bigger effect than outcome of a policy that is clearly still in place. normal, and one that was more rapidly delivered. GMO 6 Quarterly Letter – Night of Living Fed – October 2010 The Stimulus to Home Building from Rising Prices cost of adding to other longer-term problems. But state What makes a rise in house prices so dangerous, however, and local governments were left – and remain today – high and dry. Their loss of capital gains on equities coincides is that it can cause a great surge in home building. with a much more drastic loss of property taxes, which Recently in the U.S., home construction rose to 1 million more houses per year than trend line average. As far as has the added sting that property values take several years to catch down to new lower price levels. we can tell, this increase led directly to a 1.5% jump in the workforce. With the related surge in realtors, mortgage States and municipalities thus made the painful mistake brokers, and bankers, let’s say that number is closer to common to pension funds and endowments: they became 2%. There was also the extra stimulus that more rapid acclimatized to the taxes on higher asset prices over so long house turnover delivered for household furnishings and a period that they assumed them to be a new high plateau. appliances. Aformidable total. They basically built these higher prices into their budgets. Similarly, endowments did not calculate payouts based on We can deduce that without this burst of extra employment from increased home building activity, unemployment the fair value of assets; they merely “normalized,” using the average of the last ﬁve abnormally high years. In the between 2003 and 2007 would have been even higher. It is same way, pension funds did not materially adjust their a reasonable deduction that the beginnings of a structural target returns downward. These (at around 8% nominal) problem with the population of mid- and lower-skilled would be at the outer boundaries of reasonable, even if we workers would have been revealed had it not been for the were dealing with a decade with above-average inﬂation, abnormal level of house building. The “jobless recovery” combined with a reasonable or below average P/E, say, as would have been seen back then as a crisis. occurred in the ’70s and ’80s. But since 1995, we have When the housing boom inevitably ended, all of these been dealing with below-average inﬂation and persistently above-average P/Es, which is to say, lower imputed temporary advantages were given back with interest. returns. Absolutely no adjustments have been made. House construction dropped to just above half normal, delivering almost by deﬁnition a greater than 2% increment to unemployment. The bad news is that the jobs related Abnormally High Proﬁt Margins Also Misled to abnormally high house building will not, of course, Compounding this problem, which for endowments has reappear for some time, perhaps not for 10 or 20 years. already resulted in severe cuts and for pension funds is Or even longer. Completely new jobs must be found for a looming disaster, is a third factor that is even easier to miss: above-average pro ﬁt margins. For long-term this small army of the housing-related unemployed. budgetary purposes and for establishing fair value for To make a bad situation worse, the housing bust has badly global equities, variations in pro ﬁt margins are an even reduced the free ﬂow of labor across state lines, which more potent variable – and very variable indeed – than is now at the lowest percentage ever recorded. Labor are P/E ratios or in ﬂation. The ’70s had margins well mobility is particularly necessary when unemployment is below average and the ’80s were average, but since as high as it is now. But with positive equity in houses 1995, we have lived in an above-average pro ﬁt margin suddenly having turned into negative equity, and with world as well as an above-average P/E world. But the some hope (justi ﬁed or not) that housing prices may fact that this environment has persisted for 15 years most recover, many of the unemployed and others will simply emphatically does not make it normal. It just guarantees not move. that most models and almost all committees will accept it as normal. And we have had some rude shocks on the P/E Inﬂated Asset Prices Cause Faulty Budgeting front, coming down from 35 times in the U.S. market to Compared to the huge effect that higher house prices had less than half that in a decade, which, not surprisingly, is on the economy from 2001 to 2006, the effect of rising a decade that has delivered negative returns. The second shoe to drop is likely to be a similar effect on pro ﬁt stock prices was probably quite mild. But together, they had a powerful destabilizing effect on tax revenues, ﬁrst margins. In this way, pension funds, endowments, states, inﬂating them and then crushing them as prices fell. The and municipalities have all become collateral damage to Federal government, with its unique right to print money, a Fed policy that resulted in abnormally high asset prices. could counter this effect and smooth it out, albeit at the But these higher prices were, regrettably, not permanent. Quarterly Letter – Night of Living Fed – October 2010 7 GMO The Fed “Succeeds”: Higher Asset Prices Exhibit 4 Fed “Success”: The Greenspan-Bernanke Era of Overpriced Markets 5.0 4.8 1987 Greenspan arrives 4.6 4.4 4.2 4.0 3.8 + 2 Std. Dev. 3.6 3.4 U.S. Household Net Worth / GDP Historical Mean (1952-1996) 3.2 3.0 - 2 Std. Dev. 2.8 19521955195819611964196719701973197619791982198519881991199419972000200320062009 Source: BEA As of 6/30/10 Exhibit 5 Fed "Success": Blood Out of a Stone – The Fed Provides the First Housing Bubble in History Median house price/median family income 4.2 June prices 0.8% above trend… would have to fall 11% to hit 1-standard-deviation cheap 4.0 3 std 3.8 3.6 2 std 3.4 1 std 3.2 Price/Income 2.8 -1 std dev 2.6 2.4 -2 std dev 2.2 1976 1980 1984 1988 1992 1996 2000 2004 2008 Source: National Association of Realtors, U.S. Census BureaAs of 6/30/10 GMO 8 Quarterly Letter – Night of Living Fed – October 2010 Effects of Engineered Higher Asset Prices failing companies that they would normally have acquired at attractive prices. To see how sensitive more marginal By the 21st century, the pernicious practice of asset price manipulation had become baked into the pie. It guaranteed companies are to this effect, we took a look at the effect that stocks would be overpriced most of the time and that of negative real short-term rates on the performance of the small stocks (as representatives of more marginal the persistent overpricing would move the average higher, companies) relative to the S&P 500. Exhibit 6 shows while not, of course, changing fair value – replacement cost – at all. Investors would receive lowered dividends the results in an emphatic way: 100% of those four major and several minor periods of negative real rates show and a lower compound return. This distorted high average outperformance for the small stock group. With the Fed has been like the deliberately misplaced signal lanterns, which the Cornish, in the stormy west of England, used begging speculators to borrow at negative rates, it should to lure ships onto the rocks for plunder. Individuals, as not be surprising that they do, and that these speculative investments are not typically the Coca-Colas of the world. well as institutions, were fooled into believing that the Because of this effect, it is also probable that the regression market signals were real, that they truly were rich. They acted accordingly, spending too much or saving too rate of pro ﬁtability, particularly for weaker companies, little, all the while receiving less than usual from their has slowed. This change, in turn, seems to have caused value models to work less effectively since 2001 than was overpriced holdings. Especially in the boom periods, capital was substantially misallocated, with billions being the case for the prior 50 years. raised for worthless dotcom companies and massive overcommitment toﬁber optic cable. Even worse was the The Stimulus of the Fed Manipulation Must Always Be Repaid, Sometimes with Interest excessive percentage of GDP spent on the overbuilding of homes – basically, a nonproductive asset. Apparently, The saddest truth about the Fed’s system is that there can much of our leadership believed in the permanence of be, almost by de ﬁnition, no long-term advantage from those higher asset prices (either believed or cynically hiking the stock market, for, as we have always known played the game and miscalculated). Regrettably, the and were so brutally reminded recently, bubbles break perpetrators, in this case the Fed, did not get any plunder, and the market snaps back to true value or replacement but ended up with a ruined balance sheet. Any plunder to cost. Given the mysteries of momentum and professional be had from the booms and busts went, of course, to the investing, when coming down from a great height, markets more nimble members of the ﬁnancial community! are likely to develop such force that they overcorrect. Thus, all of the bene ﬁcial effects to the real economy This most unfortunate matter of asset price manipulation does not merely change politics and economics. It is also caused by rising stock or house prices will be repaid with desperately important to those of us in the stock market, interest. And this will happen at a time of maximum vulnerability, like some version of Murphy’s Law. What and we must make sense of it. We have mentioned lower a pact with the devil! (Or is it between devils?) returns and scrambled budgeting. More disturbingly for investment professionals, it changes the normal workings The Underestimated Costs of Lower Interest Rates of capitalism and the market. Weaker companies need more debt. Arti ﬁcially low rates that are engineered by For all of us, unfortunately, there is still a further great the Fed mean that leverage is less of a burden and survival disadvantage attached to the Fed Manipulated Prices. is easier. Similarly, the Great Bailout allowed many When rates are arti ﬁcially low, income is moved away companies that normally would have failed and been from savers, or holders of government and other debt, absorbed by the stronger or more prudent ones to survive. toward borrowers. Today, this means less income for If we look at the time frame since 2001, it is composed retirees and near-retirees with conservative portfolios, and of two periods of negative interest rates with a bailout in more proﬁt opportunities for theﬁnancial industry; hedge between. This whole era has been arti ﬁcially favorable funds can leverage cheaply and banks can borrow from the to marginal companies and leveraged companies, partly government and lend out at higher prices or even, perish the at the expense of conservative, un-leveraged blue chips. thought, pay out higher bonuses. This is the problem: there The great companies look less excellent on a relative are more retirees and near-retirees now than ever before, basis, and they have missed opportunities for picking up and they tend to consume all of their investment income. Quarterly Letter – Night of Living Fed – October 2010 9 GMO Exhibit 6 Subsidized Rates Encourage Speculation Small Cap Stocks Have Outperformed With Negative Real Interest Rates 1.5 1.4 1.3 1.2 1.1 Log Return Index of Small-Cap Stocks vs. Market 0.9 1960196219641966196819701972197419761978198019821984198619881990199219941996199820002002200420062008 1.5 1.4 1.3 1.2 1.1 Log Return Index of 1.0 Small-Cap Stocks vs. Market 0.9 1960196219641966196819701972197419761978198019821984198619881990199219941996199820002002200420062008 Line: Ratio of bottom to top 10% of market value on Ken FrenShading: 3m T-bill - TTM inflation < 0 Ratio of Russell 2000 to S&P 500 on FactSet data (2010) Source: FactSet As of 8/31/10 With artiﬁcially low rates, their consumption really drops. wheels have turned, I suspect this policy approach will The offsetting bene ﬁts, mainly shown in dramatically be totally discredited. And the sooner, the better! In the recovered ﬁnancial proﬁts despite low levels of economic meantime, as far as I can see in the data, it is probable that activity, ﬂow to a considerable degree to rich individuals an engineered low interest rate policy has no net bene ﬁt with much lower propensities to consume. This trade-off at all, even in normal times. It is quite likely in these might be worth it if the low rates also encouraged more abnormal times that it even has a negative effect – it holds corporate borrowing for capital investment, more hiring back economic recovery! and, hence, more long-term growth. We know already that increased debt does not cause an increase in long- The Last Desperate Round: Quantitative Easing, term GDP growth. We also know that this particular time, Currency Wars, and Commodity Panics capital investment by corporations is so particularly weak as to be considered non-existent. The willingness to hire And these are most decidedly not normal times. The is also unprecedentedly low, so the costs of low rates are unusual number of economic and ﬁnancial problems has higher (more retirees) and the bene ﬁts (capital spending put extreme pressure on the Fed and the Administration stimulus) are less than normal. Yet the normal effect of to help the economy recover. The atypical disharmony low interest rates can be seen to be minimal if indeed in Congress, however, has made the Federal government they exist; if they do exist, they come packaged in this dysfunctional, and almost nothing signi ﬁcant – good or bad – can be done. Standard ﬁscal stimulus at a level very dangerous game of asset price stimulus involving booms and busts. In a number of years, after academic large enough to count now seems impossible, even in the GMO 10 Quarterly Letter – Night of Living Fed – October 2010 face of an economy that is showing signs of sinking back look after inﬂation – is, in comparison, a piece of cake. as the original stimulus wears off. This, of course, puts So, what would you do? The only economic stimulus an even bigger burden on the Fed and induces, it seems, that seems to be available is the wealth effect, which is a state of panic. Thus, the Fed falls back on its last resortmild in the case of stocks, although very easy indeed to – quantitative easing. This has been used so rarely that manipulate and more intense, as it turns out, in the case of its outcome is generally recognized as uncertain. Perhaps house prices. And here is what the Fed bosses do: when the most certain, or least uncertain, is that the eventual they need help for the economy, they deliberately throw outcome will be in ﬂationary or, at best, that it will be their resources, moral and otherwise, at the markets. It’s inﬂationary unless precise and timely countersteps are all they can do. They then cross theirﬁngers and hope for taken. Knowing this, the entire ﬁnancial world acts a quick and strong wealth and animal spirit effect. Thus, accordingly: the dollar goes into accelerated decline, over during 1991, the game began, and stocks were stimulated to 5% down in the last few days (ending October 15) alone. recover from the 1991 recession. Why the dread of taking Global commodities, frightened by dollar weakness a normal recession set in I cannot guess, for the refusal to in response to QE2, have gone on a rampage, at least take mild recessions has been likened to a policy of not temporarily, with the entire CRB commodity index up 2.5% allowing forestﬁres. Such a policy weakens the resistance for the single day of Friday, October 8. Unfortunately, of the forest so that when theﬁre inevitably starts, it burns bad weather and tightening supply conditions as emerging so hot that the trees die along with the undergrowth. The countries pick up economic speed have added to this wild Fed’s intervening to push up asset prices helps retain some panic. But most disturbing of all is the response of other weaker corporate players and creates steadily increasing countries to the dollar’s decline. With the renminbi tied moral hazard. And this is certainly the choice that was more or less to the dollar, the competitive pressure on consistently made. The market gathered steam, and very China’s main export rivals such as South Korea, Taiwan, probably helped the economy recover. Then, as momentum and Japan has become immense, and the temptation for built, Greenspan swore off intervention after a second’s competitive devaluations, not surprisingly, is growing. hesitation in 1996 with his suggestion that the market might Just remember, even as we fulminate against China – and be showing “irrational exuberance.” With that idea quickly they are pretty good villains in this part of the game – abandoned and with a very unusual over-stimulation in the dollar is underpriced in purchasing parity terms, and 1997 and 1998, the market spiraled out of control and, at a yet the U.S. government is far from having even a neutral remarkable record 35 times earnings, broke spectacularly position on the dollar. We are still obviously encouraging in 2000. This, in turn, brought forth from the Fed an a further decline. This, unfortunately, makes our perhaps even greater dose of low rates and moral hazard, which justiﬁed complaints against China seem hypocritical. Our very probably curtailed the market decline. It stopped, ill-chosen program of ultra-cheap rates at all costs may uniquely in the history of equity bubbles breaking, at just end by creating a currency war. Thus, our current policy above trend line value in September 2002, when normally of QE2 is merely the last desperate step of an ineffective it would have overcorrected for several years and seriously plan to stimulate the economy through higher asset prices depleted the market’s animal spirits and, consequently, its regardless of any future costs. Continuing QE2 may be an enthusiasm to speculate. But this time, with negative real original way of redoing the damage done by the old Smoot- rates for well over two years, in 2003, 2004, and 2005, Hawley Tariff hikes of 1930, which helped accelerate a the stock market, the housing market, and all risky assets drastic global decline in trade. We may not even need responded to create the ﬁrst truly global bubble in risk the efforts of some of our dopier Senators to recreate a taking, with the lowest risk premiums ever seen or even more traditional tariff war. And all of this stems from the dreamed of: virtually non-existent. And the rest is history; Fed and the failed idea that it can or should interfere with although one, apparently, we are condemned to repeat, employment levels by interfering with asset prices. as, here we are, with risk taking bouncing back under the same old impetus. Time Out: Let’s Try To Empathize with the Fed Fiscal Stimulus Appears To Be the Only Option If you were a Fed boss and had, as one of your twin responsibilities, to look after employment, you would I’ve always been sympathetic to the general idea of justiﬁably be panicking. The other responsibility – to crowding out: that government spending displaces an Quarterly Letter – Night of Living Fed – October 2010 11 GMO equal and offsetting amount of private spending. But it is Political Consequences of the Fed’s Boom and Bust an academic argument and, although it may have a grain Policy or two of truth, it smells of the typical recent tendency Let me make a simple point for all of those who decry in economics: to be heavy on assumptions and light any and all governmental interference: in my opinion, on common sense and the real world. This concept is known, after the British nineteenth century economist, capitalism has been manipulated far more, and more dangerously, by the last two Republican-appointed Fed as Ricardian Equivalence, but to be fair to Ricardo, bosses than everything else added together. It is naïve, if there were no government statistics then, so everything fashionable, to blame the rather lame currentAdministration had to be theoretical. The same relatively small group for all of our problems. They inherited a cake already of taxpayers also owned most of the bonds, so one can baked or, better, “half baked,” and the master bakers were see how Ricardo might have gotten there. But today, the the current and former Fed bosses, and the underbaker government’s hiring someone is absolutely not the same as a private company’s hiring exactly the same person, for (not quite an undertaker, but nearly) was Hank Paulson with his “contained” sub-prime crisis. Aided by Timothy if the person is not hired, the government bears all of the Geithner at the New York Fed, they ﬁrst did absolutely costs of unemployment and the corporation none. This nothing for two years and then laid the groundwork cost is not merely welfare, food stamps, and the loss of for a bailout, the scale of which neither Democrats nor taxes federally and locally. It also includes the long-term Republicans had ever dreamed! And of all of the many cost to society of the unemployed losing their skills and mistakes of the current Administration, the worst, in my becoming less employable. For lower-paid workers, these opinion, are directly related to thisﬁasco: the inexplicable total costs may equal, on rough estimate, one-third to one- choice of Geithner, who was actually placed at the scene half of the cost of hiring them. In this situation, there is of the crime in New York and whose ﬁngerprints were no equivalence. Ahired worker who would otherwise be on the murder weapon, and the reappointment of ... gulp unemployed is simply a better bargain for the government. … Bernanke himself, about whose reappointment much Amore capitalist alternative would be to offer some or all juicy Republican criticism was made, all of it completely of the government’s savings as a subsidy to employers justiﬁed in my view. There may, however, be a small who hire lower-skilled workers. This has been tried and, ray of hope. The recent Fed appointee, Vice Chair Janet at times of severe unemployment, seems to be effective. Yellen, said not long ago, “Of course asset bubbles must The real problem starts when direct governmental spending be taken seriously!” She also said, “It is conceivable that accommodative monetary policy could provide tinder for cuts into the always limited pool of skilled workers, or a buildup of leverage and excessive risk taking.” Yes, sir! it is attempted when the pool of unemployed workers is only marginally above normal and the private sector has Or rather, madam! Apromising start. These sentiments, of course, are completely contrary to the oft-repeated begun to hire. That is “crowding out.” None of these policies of Greenspan and his chief acolyte, Bernanke. conditions applies now. It is intuitively obvious, at least tPerhaps she will slap some good sense into her boss on me, that ifﬁscal spending were directed only: a) to lower- skilled workers, b) when there is clearly an abnormal this issue. level of unemployment, or c) when you hire them only The net effect of deliberately encouraging the start of to do jobs with a high return to society, that we will all asset bubbles – particularly in the case of housing – and come out ahead and there is no equivalence. Future debt then neglecting them and leaving them to burst, created commitments are paper; current useful jobs are real life. the worst domestic and global recession since 1932. It How can we possibly be better off when the unemployed exposed intractable, structural unemployment that had who want to work are sitting idle and depressed, as their been building up. With a Congress totally at stalemate, skills decay? Be serious! With a dreadfully deteriorated this is a nearly impossible situation but one which, as infrastructure and a desperate need for improvements usual, will be associated with the currentAdministration in energy ef ﬁciency, there is certainly a great potential and therefore will cost dearly in votes. In 1966, England’s supply of high societal returns waiting to be had on one government was hopelessly behind in the vote, but was hand, and an army of non-frictional unemployed ready to saved by brilliant summer weather – in England! – and get to work on the other. by victory in soccer’s World Cup. The current situation is GMO 12 Quarterly Letter – Night of Living Fed – October 2010 the reverse. As to picking the right road to an economic time, Years 1 and 2 were turned into a sort of massive recovery, the Irish punch line would be, “I don’t think you Year 3 in which low rates and moral hazard added to can get there from here.” It would all have been so much the market’s natural reﬂex to have a big rally after a easier to prevent than to cure. major nerve-rattling decline. The market responded by rallying 82% in 13 months (to April 26, 2010), All This and Climate Change Too with risky stocks up by over 120%, both second only I joked with my wife that I would end by saying that at to the rally from the low of 1932. Also unique this least I couldn’t blame the Fed for climate change. Ho, time is the great bust of 2008 and the ensuing great ho. Then I began to think: wait a minute, without the bailout. How much difference do you want? Even housing boom and bust and the stock boom and bust, we so, I expect that the bottom line will come down to would not have had this chronic recession and intractable short rates. Surely they will stay low for the entire unemployment. This would then not have been blamed on Year 3. And, if so, the “line of least resistance” is for the market to go up and for risk toﬂourish. In the last Obama and, with less to worry about, he would not have been a “no show” on the climate debate, and we would six months I’ve guessed on separate occasions that probably have had a decent energy and climate bill. No levels of 1400 or 1500 on the S&P 500 are reachable kidding. So there you are: the Fed really is at the bottom a year from now; this still seems a 50/50 bet. If we of almost all of our problems. include more moderate market advantages, the total odds would be well over 50%. (I’m trying to wean Apologies myself from a recent dangerous habit of using precise probabilities.) Risks to this forecast are highlighted Since it is customary in polite society to apologize for causing distress, on behalf of the Fed, let me apologize by some ugly near-term possibilities. The worst for the extraordinary destructiveness of its policies for of these is that Senator Smoot and Representative Hawley, sponsors of the anti-trade bill of 1930, will the last 15 years. Bernanke’s version of an apology, delivered in January this year to theAmerican Economic pull a Night of the Living Dead and prepare a very Association, was to claim that the Fed’s monetary policy dangerous opening salvo in the next global trade war. during the 2000-08 period was appropriate, and that Indeed, today it feels as if there were an inexhaustible supply of politicians who would put their political/ there were no major failings, such as missing the housing bubble completely, that were worth mentioning. This philosophical principles way ahead of global well stubbornness in the face of clear data is right up there with being. As mentioned earlier, the Fed is also stirring up a hornet’s nest on the currency side of this issue efﬁcient market believers. And very impolite indeed. with its quantitative easing. There is also the deﬁnite Current Investing Questions possibility that we could slide back into a double dip, so we may get lucky and have a chance to buy 1) Does this year being a Year 3 of the Presidential cheaper stocks. But probably not yet. And, of course, Cycle confuse the issue? if we get up to 1400 or 1500 on the S&P, we once Yes. Exhibit 2 shows the extent of the problem. In again face the consequences of a badly overpriced Year 3, risky, highly volatile stocks have outperformed market and overextended risk taking with six of my 1 low risk stocks by an astonishing average of 18% a predicted seven lean years still ahead. And this time year since 1964 (when good volatility data started). the government’s piggy-bank is empty. It is not a Also, to repeat a favorite statistic, the record says pleasant prospect. that 19 Year 3s have occurred since FDR with not 2) Should we hold onto quality stocks? one serious bear market – in fact, just one Year 3 was down, ﬁnishing at -2%. Who wants to bet on the 20th For sensible long-term investors, the probable being different this time? Yet, if ever there were an outcome of a further speculative rally as described argument for “this time is different,” this is it, isn’t above would be irritating and resolve testing. For it? This year, a Year 3 has been preceded by two good short-term momentum players, it may be heaven abnormally stimulated years when, typically, the Fed works to cool the markets down in Years 1 and 2. This 1 “The Last Hurrah and Seven Lean Years,” 1Q 2009 Quarterly Letter. Quarterly Letter – Night of Living Fed – October 2010 13 GMO once again. Being (still) British, this is likely to be and their strong GDP growth especially, I believe that th my n opportunity to show a stiff upper lip. There is, they will sell at a premium to the S&P, perhaps a big though, one quite friendly in ﬂuence lurking around one. How much of this premium to go for depends that may help us lovers of quality stocks. They are on an investor’s commitment to pure value relative getting so cheap relative to the market that a wider to the weight that is placed on behavioralism – the range of buyers is ﬁnally noticing them. In the third way investors really behave versus the way they quarter, in a market up a signi ﬁcant 12%, quality should behave. This gives us quite a wide range stocks held the market. To say the least, this has not for investing in emerging that might be considered been the law of nature recently: for the past eight reasonable. GMO will make its own decision on how years, quality stocks usually won in down quarters “friendly” to be toward emerging market equities as a and usually lost badly in extreme up quarters. That category. You must make yours. the Fed Manipulation of Prices was still in force and that this was not a “risk off” quarter was proven by 4) What to do about raw materials? the continued outperformance of small caps and The “running out of everything” thesis that I dropped riskier stocks. So the better performance of quality into a black hole a little over a year ago (2Q 2009 stocks was clearly a bargain effect and not an anti- Quarterly Letter) is creeping out of its hole (helped risk move. This may be grasping at straws, but if by the Fed’s mooted QE2), and at least the idea of the expected speculative rally takes place in this generalized shortages is heard now and then. The last Year 3 starting now, I believe that there is a decent two weeks (October 3-17) have been truly remarkable chance, say one in three, that quality stocks are so for commodity prices: on October 8 alone, the entire cheap that they will “unexpectedly” hang in. And, commodity index was up 2.5%! Tin, for example, is after this next 12 months, the odds move in our favor, at an all-time high (in nominal prices, I admit) and, and I believe (once again speaking for myself) that high quality stocks should have an even bigger win more importantly, “Doctor Copper” is almost bac
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