Hedge Funds Gone Wild
by Doug Noland
February 15, 2013


I posited that Mario Draghi this past summersinglehandedlyaltered the global financial landscape. This miraculous feat was made possible with his bold guarantee of unlimited ECB bond purchases to backstop troubled euro-zone bond markets and system liquidity more generally. As soon as the marketplace became comfortable that his backstop was credible, the “Draghi Planfundamentally altered the risk vs. reward calculus for holding and shorting European periphery debt. This abrupt change in debt market perceptions then worked to reverse the crisis of confidence imperiling the soundness of Europe’s banking conglomerates, the region’s economic prospects and the euro currency. 

Importantly, the global leveraged speculating community was forced to cover short (bearish) positions in Europe - and many reversed course and established long holdings. Illiquidity and capital flight risk were transformed into liquidity abundance and major financial inflows. An impending catalyst for a problematic bout of global de-risking/de-leveraging (“risk off”) was quashed. For “global macro” and global risk markets, this proved a game changer.

During bouts of acute financial stress over the past few years, European officials repeatedly protested that they were under the attack of the hedge fund community. It is, then, ironic that the Draghi Plan incentivized leveraged player purchases that boosted marketplace liquidity and dramatically lowered market yields in Spain, Italy, Portugal, Greece and Ireland. Following in the footsteps of the Federal Reserve, to stem Europe’s deepening crisis Draghi had to create an enticing backdrop for leveraged speculation. 

Last summer’s crisis was rapidly becoming a global systemic issue. The global move to more open-ended quantitative easing – especially by the Federal Reserve and Bank of Japan – was part and parcel to a concerted global central bank response to systemic fragilities. 
And I recall clearly how the Mexican bailout in 1995 emboldened the speculator community and spurred dangerous Bubble excess in South East Asia, Russia and the developing markets throughout 1996. The late-1998 LTCM bailout and Fed reliquefication emboldened the speculators and played an integral role in the 1999 Bubble melt-up in technology stocks and the U.S. equities more generally. I’m monitoring for indications that the “Europeanbailout might spur a major bout of speculative excesses in 2013. 

Granted, a billion dollars just isn’t what it used to be. But according to The Wall Street Journal, George Soros’ hedge fund “has scored gains of almost $1 billionshorting the yen over the past few months.

From the WSJ (Gregory Zuckerman and Juliet Chung’sU.S. Funds Score Big by Betting Against the Yen”): “Some of the biggest U.S. hedge-fund investors have made billions betting against the yen, exploiting Japan's determination to weaken its currency and boost its economy. Wagering against the yen has emerged as the hottest trade on Wall Street over the past three months… The growing trade has itself helped pressure the yen, which has slid almost 20% in about four months. That, in turn, is helping fuel what could become a world-wide currency war. Countries such as Germany and France have criticized Japan's policies, while others have threatened to take action to reduce the value of their own currencies to remain competitive with Japan.”

And from the Financial Times (Sam Jones and Dan McCrum’s “‘Abe Trade’ Revives Macro Hedge Funds”): “Shorting yen and buying Japanese equities, inspired by the dovish monetary bent of Japan’s new prime minister, Shinzo Abe, has been one of the most successful hedge fund wagers in years. And many believe it is a harbinger of greater macroeconomic dislocations and greater opportunities. Since 2010, the blue-bloods of the world’s $2tn hedge fund industryso-called global macro managers – have been cowed by rangebound markets that have been dominated by choppyrisk on, risk off movements. Global macro stars, who specialise in trading interest rates, bonds and currencies to play the ups and downs of the world economy have not just struggled to make money, they have struggled not to lose it.”

I posed the question last week, “New Bull or Bigger Risk On, Risk Off? Europe fragilities were instrumental in the “choppy risk on, risk off movements” throughout global markets over the past two years. This highly unsettled backdrop forced the big macro hedge funds – and traders/speculators more generally – to keep trades on short leashes (risk control measures that chipped away at performance). We now see indications that the big players have been unleashed, at least as far as taking – and winninghuge bets against the yen.

More from the FT: “For many of them, the prospect of ‘currency wars’ and a breakdown in the international economic consensus will make for the kind of investment opportunities they have been desperate for since 2008. The next few months are rich with potential opportunities, they believe, whether shorting sterling in anticipation of laxer monetary policy…; buying up equities to trade on institutional investors’ rotation away from bonds; or investing in commodities such as palladium to capitalise on a race for devaluation among the world’s big currencies. ‘I think it’s the rebirth of global macro,’ says the head of one of the world’s top five global macro hedge funds. ‘For the last three years we have had this rangebound environment, and now it looks like individual currency actions, individual countries acting, are going to start to dominate.’”

The “rebirth of global macro”? Greater macroeconomic dislocations and greater opportunities”? There are different angles of the analysis to contemplate. First of all, we’re seeing important confirmation in the thesis that heightened global fragilities and aggressive policymaker responses have incited only more aggressive risk-taking. There is, as well, support for the view that currency markets have become a key battleground for the speculator community. Policy measures have been unprecedented – and I would argue Bubble excesses have been commensurate. With the euro situation seemingly stabilized in the short-term, the backdrop became ripe for a big bet against the yen. And with the new Abe government supportive of aggressive Bank of Japan money printing and a weaker currency, some of the “community” of big funds pounced.

The bearish yen trade has been a big winner. Will the speculators pile on? Will proceeds from yen selling provide liquidity for bullishrisk onmarket bets globally? Could indiscriminate selling potentially risk inciting a freefall in the yen? If yen weakness turns disorderly, could this negatively impact Japan’s vulnerable bond market? Or could developments elsewhere (Europe?) shift the backdrop away from today’s globalrisk on,” in the process inciting an abrupt reversal in the yen and another painful short squeeze? This yen situation has potential to be an integral facet of a “Bigger Risk On, Risk Offglobal market dynamic.

From a “risk onperspective, the big macro funds holding onto gains would ensure that they’d be on the receiving end of fund inflows. They would enjoy greater firepower – and confidence – for which to pursue bigger macro bets. And their success would have the leveraged speculating community and global traders alike determined/desperate to participate in the next big trade. The big win on the yen could have important financial and psychological ramifications for an expanding global Bubble backdrop.

Lurking Big Risk Off is a potential consequence of unfolding Big Risk On. The Europeans today have no qualms with the global leveraged speculators actively buying their bonds. But many are increasingly frustrated by the strong euro - and they’ll be mad as hell again when the speculators start liquidating and shorting their debt. The Japanese are these days fine with the hedge funds pushing the yen lower. Yet with Japan’s stupendous debt load, it brings to mind the oldbe careful what you wish for.” An attack on Japanese bonds would be problematic. 

Meanwhile, much of the world is increasingly frettingcurrency wars” and “competitive devaluations.” No one seems to have an issue when speculators bid up stock and bond prices. Increasingly in the currency markets, however, countries are looking at the situation as a zero sum game. “Developingpolicymakers, in particular, are about fed up with “hot moneyinflows inflating their currencies. Yet global central banks have created such abundant liquidity conditions that currency speculation seems likely to gain further momentum. In our unstable financial and economic worlds, policy measures have come to dictate currency and risk market behavior. This plays right into the hands of a global pool of speculative finance that – bull market, bear market, crisis or recoveryonly seems to inflate larger by the year.

And Friday from Bloomberg: “Billionaires Soros, Bacon Cut Gold Holdings as Price Slumps.” The big hedge funds have been major operators in the gold market. As “risk on” has gained momentum, so-calledsafe havenassets have lost some luster. Gold, Treasury bonds and German bunds have all stumbled in early-2013. And in this trend-following and performance chasing financial landscape, funds are compelled to sell the underperformers and buy what’s inflating in price in order to survive. With safe havens out of fashion and cash a total loser, “moneyflows freely to the inflating riskier assets. Funds aggressively playingrisk onattract strong inflows and greater financial power, while those cautiously positioned lose assets and are forced to liquidate lower-risk assets. Meanwhile, buoyant risk markets work wonders on bullish market sentiment. 

At the same time, there is also ongoing confirmation that the incredible global policymaking and liquidity backdrop is much more successful in inflating asset markets than it is in boosting economic performance. In particular - and especially considering policy environments - economies in Europe, Japan and the U.S. continue to un-impress. This bolsters the view of a widening global gap between inflating financial asset prices and underlying economic fundamentals.

This begs the question: how might the emboldenedglobal macrocommunity play this divergence? Will they play policymaking and the inflating Bubble for all it’s worth? Or will they begin to approach speculative markets with a more contrarian bent? With some funds emboldened and still so many others desperate for performance, it seems reasonable to assume that markets become even more speculative – a game of trying to catch folks on the wrong side of trades (i.e. Apple, gold, etc.), underexposed to outperforming sectors (i.e. homebuilders, high-beta and “shortstocks) and overexposed to the underperforming (i.e. “defensive”). Most call it a “new bull market”. I’ll stick with “inflating speculative Bubble”.

Investing in a Low-Growth World

John Mauldin

Feb 16, 2013

The juryunless you are the Fed and Ben Bernanke or the Congressional Budget Office, which cannot make lower growth assumptions without really blowing their deficit projections out of the water – is pretty well in on GDP growth: it’s going lower. Ed Easterling and I wrote a recent Thoughts from the Frontline on multiple pieces of research suggesting slower future growth.

We asked the question, “So what about stock prices; will they follow suit?” Our thought was that, over time, they would.

Not so fast, says Jeremy Grantham in today’s Outside the Box. He was part of the cabal of researchers suggesting slower future GDP growth whose work we used as the basis for our analysis. Longtime readers know that I think Jeremy Grantham (who heads GMO, which now manages $106 billionsee GMO LLC for more wonderful GMO team research) is one of the smartest men on the planet as well as one of the best investors. With his usual thoroughness, Jeremy makes the case, based on in-house research, that both stock-market returns and corporate earnings growth are negatively correlated to GDP growth. At the same time, he’s not overselling his thesis:

For the record, there is also: a) a moderate relationship between higher-priced countries (on Shiller P/E and price/book) and future underperformance; and b) a tendency for more rapidly-growing countries to be overpriced.

Therefore we can deduce a logically appealing (but statistically weak) tendency for overvaluation to contribute a second reason for the market underperformance of more rapidly growing countries. (Please notice how carefully said that is.)

He goes on to reiterate important points he has made over the past few months about the effect of growing resource costs on growth, and then adds:

The main new point I wanted to make was that resource costs are treated like GDP increases. Hence, prior to 2002, steadily falling resource costs were treated as a debit when of course steadily lower costs were a great help to well-being and utility. We calculated that adjusted GDP actually grew 0.2% a year faster than stated. Conversely, since 2000, rising costs were a detriment, not a benefit, as shown in GDP. Treated correctly as a negative, resource costs would have reduced real growth by 0.4% a year. This squeeze on growth will continue as long as resource costs rise faster than the growth rate of the balance of the economy.

Always careful of the ground he stands on, Jeremy then throws in a very important caveat to say:

… it is worth remembering that we don’t really know what caused resource prices to spike from 2002 to 2008 so impressively. This was a much bigger price surge than occurred during World War II! Indeed, it may easily turn out that the resource price rises will squeeze future GDP growth substantially more than our estimates.

Or not.

In any case, a careful reading of Jeremy’s work is always instructive. This one is an important think piece, as the direction and magnitude of future GDP growth will be critical as we make business, retirement, and investment decisions. Simply talking past performance is risking your future on the unlikely prospect that the future will look like the immediate past.

I am personally doing a lot of thinking and research on this topic. I strongly suspect that other significant factors will arise to play havoc with projections, in both fantastically positive and uncomfortably dire ways. I am more and more seeing the future as verylumpy,” that is, quite uneven as to how it will affect individuals and even entire countries. For those who espouse more equality in incomes and outcomes, this is not your optimal scenario. But even with all the “lumpiness,” the average person will be much better off in 20 years – though “average” will cover a much wider spread of outcomes than it does even today.

But rather than launch into that book now, we’ll let Jeremy take over.

Have a great weekend.
Your looking forward to catching up this weekend on my reading analyst,
John Mauldin, Editor
 Outside the Box

Investing in a Low-Growth World

By Jeremy Grantham

This quarter I will review any new data that has come out on the topic of likely lower GDP growth. Then I will consider any investment implications that might come with lower GDP growth: counter intuitively, we find that investment returns are likely to be more or less unchanged – a little lower only if lower growth brings with it less instability, hence less risk. Finally I will take a look at the reaction to last quarter’s letter, specifically about my outlook for lower GDP growth.

Recent Inputs on a Low-Growth Outlook

Some information came out after the 4Q 2012 Letter or was missed by us and is worth mentioning. First, the Congressional Budget Office slashed its estimate of the U.S. long-term growth trend from 3.0% to 1.9%! Given the source and the magnitude of the adjustment, I think it is fair to say that their number is “close enough for government work” to our 1.5%. At least it is within negotiating distance.

Next, a report from Chris Brightman of Research Affiliates actually came out a week before ours and concluded that long-term GDP was 1.0%, a number that really corresponds to our 1.5% because his report has no reference to our two special factors, resources and climate, which take our 1.5% to 0.9%. I was encouraged by the solidness of his research. It also led me to an article in the Financial Analysts Journal (January-February 2012) by Rob Arnott and Denis Chaves. Rob has been writing about the effects of age cohorts on investment returns for almost as long as I can remember, with the central idea that older people are sellers of assetshouses as well as stocks – that younger members of the workforce buy. But they also include the aging effect on GDP growth, which he shows taking a real hit in all developed countries (except Ireland). They are commendably careful in suggesting that their model may be wrong. When or if you read this article, you will certainly hope that it is indeed wrong, for their models estimate from past experience a far greater drop in GDP growth than our work assumed last quarter. And they certainly attacked that aspect in far greater detail than we did.

We had included in our report the effect of aging on the total percentage of the population of working age: there are simply fewer workers and more retirees in the distribution. But Rob and Denis (sorry for the liberty) introduce the incremental idea, apparently provable, that older workers lose productivity, no doubt much more in heavy manual work than, say, in writing this. But definitely alas, including all activities with dire consequences, they argue for productivity and GDP growth.

Would Lower GDP Growth Necessarily Lower Stock Returns?

This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability. (At least not in a major way for, as we shall see later, there may be some indirect or secondary effects that may very modestly lower equity returns.)

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse.

For there to be a stable equilibrium, assets, including entire corporations in the stock market, must sell at replacement cost. If they were to sell below that, no one would invest and instead would merely buy assets in the marketplace cheaper than they could build themselves until shortages developed and prices rose, eventually back to replacement cost, at which price a corporation would make a fair return on a new investment, etc.

The history of market returns completely supports this replacement cost view. The fact that growth companies historically have underperformed the marketprobably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of “valuestocks began to overwhelm the earlier logically appealing idea that growth should win out.

It was clear that “value” or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market’s faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain’t so. And we at GMO have (somewhat reluctantly for competitive reasons) been talking about it for a few years.

Exhibit 1

GDP Growth Unrelated to Stock Returns


Exhibit 1, shown by us before, shows the moderately negative correlation between GDP growth by country along with their market returns. This is shown for the last 30 years only and for developed countries only, but in earlier work we went back a hundred years for some developed countries and looked at emerging country equity markets as well and all had the same negative correlations. (See Ben Inker’s white paper, “Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns”, August 10, 2012, at www.gmo.com [registration required].) When I asked my colleague Ben Inker if this was for the same reason that growth companies underperform that they are overpricedBen came up with another completely sufficient explanation (in about 10 seconds): the faster-growing countries, at least for the last 30 years, have simply had more slowly-growing earnings per share.

This is shown in Exhibit 2. For the record, there is also: a) a moderate relationship between higher-priced countries (on Shiller P/E and price/book) and future underperformance; and b) a tendency for more rapidly-growing countries to be overpriced.

Therefore we can deduce a logically appealing (but statistically weak) tendency for overvaluation to contribute a second reason for the market underperformance of more rapidly growing countries. (Please notice how carefully said that is.)

Exhibit 2

Earnings Growth Is Negatively Correlated with GDP

Would Lower Real Rates Lower Stock Returns?

Economic theory can’t get everything completely wrong, and perhaps one thing economists have gotten partly right is that the risk-free rate has some relationship to the growth rate of the economy. If that rate approaches zero, there is clearly less demand for new capital; in fact, given accurate depreciation accounting, there would be zero net new capital required. It is also easy to see the risk-free rate settling at something around nil. The risk premium, however, might be little affected. The demand for risk capital e.g., to replace an old plant, resulting in no new net growth – would still require that the investor expect an adequate return. If it looked likely to be less than that, he would of course withhold his capital until inevitable shortages pushed up profits enough for the corporation to get a satisfactory return, as we have often discussed.

However, and I bring up this complicated issue with trepidation, it does seem possible that in a world with both lower growth and a lower risk-free rate that the risk premium might also drop a little. A lower growth world might plausibly be less volatile because managing a world where the apparent growth is 1.5% (and real growth is 0.9%) is likely to be easier to stabilize than one (as from 1870 to 1995) appearing to grow at 3.4% but actually growing at 3.6%, almost four times higher. (Another way of stating my negative 0.5% resource adjustment, by the way, is to say that the economy’s costs are growing at 1.5% but that its utility – or something closer to utility than GDP anyway – is only growing at 0.9%.) If returns to equity holders are to fall, then P/Es must paradoxically rise to bring yields and total returns down. Yet, as always, equities have to sell at replacement cost.

Therefore the books have to be balanced by returns on equity falling. This after all seems reasonableif returns on T-Bills drop and returns to stockholders drop, then a system in balance would suggest that returns on corporate investment also drop. This adjustment would likely be modest and should only occur if a lower-growth world were to become less likely, which is far from certain, merely plausible.

Reflections on Our Work on Lower-Growth GDP

With a few months to reconsider the data, old and new, I would have framed last quarter’s issue on declining growth differently to emphasize how routine, even friendly, most of our inputs were. The main new point I wanted to make was that resource costs are treated like GDP increases. Hence, prior to 2002, steadily falling resource costs were treated as a debit when of course steadily lower costs were a great help to well-being and utility. We calculated that adjusted GDP actually grew 0.2% a year faster than stated. Conversely, since 2000, rising costs were a detriment, not a benefit, as shown in GDP. Treated correctly as a negative, resource costs would have reduced real growth by 0.4% a year. This squeeze on growth will continue as long as resource costs rise faster than the growth rate of the balance of the economy. Further, as the percentage of the GDP taken up by resources has recently more than doubled (2002 to 2012), the squeeze on the balance of the economy would also be doubled even if the rate of cost increases stayed constant.

Last quarter I estimated that continued increases in resource costs from now to 2050 would lower GDP growth by 0.5%. To prevent that 0.5% effect from accelerating as the share of resources in GDP rises, the rate of resource cost increases must decelerate from the recent 7% a year to a much more modest 2% a year by 2050. (By then, of course, it might well be over the current 7% ... it is just not knowable.) As one can see, this is not nearly as draconian an assumption as it might initially appear to be and in this context it is worth remembering that we don’t really know what caused resource prices to spike from 2002 to 2008 so impressively. This was a much bigger price surge than occurred during World War II! Indeed, it may easily turn out that the resource price rises will squeeze future GDP growth substantially more than our estimates.

Although our low estimate of future GDP growth attracted attention and plenty of opposition, it was only produced as a necessary backdrop to show the potential significance of our two new points: the large deduction for a cost squeeze from resources (0.5%) and a very slight but increasing squeeze from climate damage (0.1 rising to 0.4 after 2030), which latter deduction is considered almost ludicrously conservative by that handful of economists that study the costs of climate change. Our work on the traditional aspects of GDP growth was approached by us as a necessary chore; we were not looking for trouble. Consequently, we tried to keep it simple by using the obvious data sources.

Where on earth did GMO get its pessimistic population data?” ran one complaint. Well, would you believe the U.S. Bureau of Census? And as for productivity, we extended the 1.3% average for the last 30 years out for 30 more years. This is clearly a very friendly assumption given: a) the recent 1.3% in productivity growth of the last 30 years had declined a lot from its 40-year surge of 1.8% after World War II; and b) the fact that the segment of much higher productivity – manufacturing – has declined to a mere 9% of total labor from 19% in 1980 and continues to decline.

Even my one override, -0.2% a year for the next 18 years as a result of much-reduced capital spending, seems, based on econometric modeling, to be a very modest debit. For there to be so modest a negative effect needs capital spending to drift back toward normal in the relatively near future. And even then this -0.2% effect was exactly offset in our forecast by a +0.2% bonus for the unanticipated surge in fracking activity and the ensuing burst of momentarily cheap energy. So why the fuss? The resource debit merely reflects the remarkably odd GDP accounting that counts an unfortunate surge in necessary costs as a benefit, and the remaining 1.5% is merely reflecting recent data . Higher growth assumption, Mr. Bernanke should be aware, must prove longer-term improvements in productivity or, tougher yet, increased labor input.

Short-Term Behavioral Impacts on the Market from Lower GDP

Of course, in the short term there are always temporary behavioral responses. If GDP growth drops unexpectedly, corporations might easily be caught mis-budgeting or overexpanding (although this current ultra-cautious U.S. corporate system, which only reluctantly makes capital investments, is unlikely to be caught out too badly), and perhaps more importantly investors may be shocked by continuous revenue warnings, which might cause the market to sell off. Recent corporate announcements, while usually still claiming exceptional profit margins and generally hitting earnings targets, are increasingly missing revenue targets and issuing future revenue warnings. We must admit, though, that recent revenue warnings have not stopped the market from rising, nor has the unexpectedly slightly negative growth for the fourth quarter GDP.

Within sectors there would quite likely also be a shift in preferences. Growth stocks might seem relatively more attractive: “If the system isn’t growing, the least I can do is pick a few companies that clearly are still growing.” Perhaps quality franchises would also become more appealing with the logic being that at least in the transition to lower top-line revenue growth, competition would become more severe and, hence, defensive moats even more than usually desirable.

Engineered Low Interest Rates


The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time. This low interest rate period is serving, therefore, as a sneak preview of what a permanently lower rate regime might look like (although any permanently lower rates reflecting lower GDP growth would be by no means as low as these engineered rates that we are currently experiencing). So what are some of these effects? The artificially low T-Bill rates first work their way slowly up the curve. Next, the most obviously competitive type of equitieshigh yield stocksbegin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea. Then, this low rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap ratesslowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise. The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost.

Then, if the heart of capitalism is still beating at all, a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets houses or stocks or bothfar over replacement value, followed eventually, at long and hard-to-predict intervals, by exciting crashes. No way to run a ship, but it does produce an environment that contrarians like us, who can take a few licks, can thrive in.)

Stock Option Culture Messes Things Up

The normal capitalistic response described above runs smack into the new tendency for corporations to either sit on money or buy stock back (regardless of how expensive it may be!), which works in the opposite direction to create shortages, drive prices up, and, as a by-product, lower job creation and GDP growth. So where does this all come out? You tell me. All that I know is: a) if we in the U.S. don’t invest, others will and it will, in the longer run, definitely end badly; b) that even if there is a lower-return world in the future it is still better to own the cheaper assets; and c) it behooves buyers of “cap ratetype assets like real estate to realize that the current low rates are flattered by current Fed policy, which will, like everything else in life, pass away one day, leaving them looking overpriced. It can’t be too soon for me. In the meantime for us at GMO it means emphasizing care and maintaining a heightened sense of value discipline, not only in stock selection, as the whole world is once again bid up over fair value in a way so typical of the post 1994 era, but also in forestry and farmland. GMO has investments in those areas too and recognizes the need to sidestep overpricing by emphasizing the nooks and crannies. Fortunately there are more nooks and deeper crannies in forests and farmland than there are in almost any other area, certainly including stocks.

Danger of the Fed Overestimating Growth

This doesn’t really fit in with a quarterly letter emphasizing important good news, but being about the Fed, I have to make an exception. The Fed appears to be still assuming a 3% growth rate for future U.S. GDP. It would be safer and more confidence-inspiring, now that Bernanke appears to take his responsibility for growth seriously, that he at least have a reasonable growth target (preposterous as that notion is to me that the Fed should or even could affect long- term growth simply by messing about with interest rates). The growth in available man-hours has definitely declined by about 1% a year, yet Bernanke’s assumption for our GDP’s normal trend growth appears unchanged at its old 3%.

Ergo, he must be assuming an offsetting rise of 1% in productivity. But why? We should treat these assumptions quite seriously for this is famously (for me) and painfully (for all of us) the man who could not see a 33⁄4-standard- deviation housing market, and indeed protested that all was normal, etc., etc., etc. (

(Dear handful of niggling readers, this 33⁄4-standard-deviation event is calculated on the assumption of a normal distribution, as is often done in investing, even though we [especially at GMO] know this is not true but is just a convenient statistical device. In fact, we at GMO know quite a bit more on this topic for we have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330bubbles,” 36 of which we callmajor, important bubbles,” which we define as 2-standard-deviation events, given the same assumption.

Well, a 2-sigma event should occur every 44 years in a normally distributed world and they have occurred every 31 years. This is much closer to random than we had previously thought. Yes, financial asset data is fat-tailed; that is, there are more outlying events than are found in a normally distributed series, but they are not extremely fat-tailed. They show up as 2-sigma events but occur as often as 1.8-sigma events would occur in normal distributions. Extrapolating, we can assume that Bernanke’s 33⁄4-sigma housing bubble would occur, adjusted for our fat-tailed real-life history, not every 10,000 years, but somewhere more like 1 in 5,000 years! I previously used “a 1-in-1,200-year event” as a casually selected very large number to describe the 2006 housing bubble. But under challenge, these current numbers are more accurate. No, this does not mean we have 10,000 years of data or even 5,000. It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one. I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy).

I assume he keeps beating it until it either turns into a horse or drops dead from too much beating! Fine-tuning economic growth, an impossible job for the Fed anyway, is hardly likely to get any easier by badly overstating trend-line growth. It seems nearly certain, therefore, that the Fed will keep trying to whack the donkey for far too long. The likely consequences of this policy are, to be frank, over my head, but my colleague Edward Chancellor will address them briefly if I can nag him effectively.

Investment Implications

Courtesy of the above Fed policy, all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome! But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced. European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced. Notably, U.S. stocks (exquality”) now sell at a negative seven-year imputed return on our numbers and most global growth stocks are close to zero expected return. As for fixed incomefugetaboutit! Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occursaccelerating inflation.

When one combines the apparent determination and influence of those who do the bullying with the career risk and short-termism of the bullied and the desire of the general public to believe unbelievable good news, these overpricings can go much further and the Fed can win another round or two. That’s the problem. A clue to timing would be when we begin to hear more passionate new era arguments: profit margins will always be higher; growth will snap back to 3% for the developed world; and new ones I can’t think of ... maybewhen the discount rate is this low the Dow should sell at, perhaps, 36,000.” In the meantime, prudent managers should be increasingly careful. Same ole, same ole.