The Great Reset, Part Two

By John Mauldin


“Premature optimization is the root of all evil…”

– Donald Knuth, from his 1974 Turing Award lectura


This is the second of two letters that I think will be among the most important I’ve ever written.

These letters set out my philosophy about how we have to invest in the coming days and years.

They are the result of my years spent working with clients and money managers and thinking about the economic and particularly the macroeconomic world. Because of some of the developments I will be discussing, I think the future is likely to be extremely challenging for traditional portfolio allocation models. In these letters I also discuss some of the changes in my thinking about the new developments in markets that allow us to more quickly adapt to a changing environment – even when we don’t know in advance what that environment will be. I hope you today’s letter helpful. At the end I offer a link to a special report with more details.

Last week I discussed what I think will be the fallout from the Great Reset, when the massive amounts of global (and especially government) debt and the bubble in government promises will have to be dealt with. I think we’ll see a period of great volatility in the markets.

I offered a solution for dealing with this complexity and uncertainty in the markets by diversifying trading strategies. But that diversification must reflect a rethinking of Modern Portfolio Theory, including a significant reshaping of valuations in asset classes. We’ll deal with those topics today.

Modern Portfolio Theory 2.0

I think successful investing in the future will use a variation of Modern Portfolio Theory. MPT argues that you should diversify among noncorrelated asset classes to reduce overall portfolio volatility.

That strategy is wonderful when asset classes are truly noncorrelated – but we found out in 2009 that noncorrelation isn’t a reality anymore. Going forward, I think it will be more useful to diversify among noncorrelated trading strategies that are not committed to a buy-and-hold process for any particular asset classes. Call it MPT 2.0.

There’s a story here about how my thinking has changed on how we deal with Modern Portfolio Theory. About a decade ago, I gave the luncheon keynote speech at a major alternative investment (hedge fund) conference, on why I thought Modern Portfolio Theory no longer worked. My talk had to do with the rising correlation among asset classes and was an argument for active management and, yes, hedge funds (which of course the audience liked).

The next year the conference organizers invited Harry Markowitz, the Nobel Prize winner who developed the theory, to do the same luncheon keynote. That year, I was speaking at the conference later in the day.

Before Harry’s speech, I met him (for the first of what would be many times) out in the hall and began to question him, based on what I thought I understood about Modern Portfolio Theory. (Yes, there was hubris there – and worse.) Politely, with a smile as if he were lecturing a new student, Harry began to explain to me why I didn’t understand what he was saying, and he commenced drawing quadratic equations in the air with his fingers to explain his points.

What was so remarkable (I swear this is true) was that he was drawing the quadratic equations in reverse so that I could read them. Once I realized what he was doing, I was so stunned that someone could even do that I really didn’t hear much of anything else he said. We talked politely for about 10 minutes, and then he moved on. I don’t think I recovered for a week. But because I didn’t understand what he was saying, I still thought he was wrong.

A few years later, my friend Rob Arnott invited me to his annual Research Affiliates client program, where Harry was in attendance. I reminded him of our conversation and asked the same question I had before, and once more he began to try to get into my feeble brain what he was saying. I will admit he just wasn’t connecting. But Rob kept inviting me back; and as Harry was an advisor to his organization, we renewed our acquaintance annually and became what I like to think of as Friends.

Let me provide a little background on Harry. When his seminal paper was published in 1952, he had just left the University of Chicago to join the RAND Corporation, where he worked with George Dantzig on linear programming and the critical line algorithm that ultimately led to the concept of mean variance optimization. What I think is interesting is that the goal of linear programming at the time was to determine the best outcome in a model (i.e., to maximize profit subject to cost constraints or minimize costs subject to profit constraints/targets – typically applied to the allocation of resources in industrial companies or government agencies). In the 1940s, Dantzig had developed his ideas in work he did for the US Air Force, work he subsequently shared with John von Neumann, the father of game theory. Linear programming has been used to program models of transportation, energy, telecommunications, and manufacturing. The work Harry did in taking linear programming to the next level leads me to think of portfolio construction in terms of “engineering” a portfolio with whatever ingredients are available (stocks, bonds, asset classes, or trading strategies).

Interestingly, Markowitz’s work didn’t achieve importance until the early ’70s, when stocks and bonds got slammed at the same time. It had taken 20 years for his ideas to get a serious look. In addition to the movements in the stock and bond markets that were changing investors’ understanding of risk and its relationship to returns, the development of computing power and the founding of the Cowles Commission and CRSP (The Center for Research in Security Prices) at the University of Chicago gave Harry’s theories new life.

Back let’s turn back to engineering and the concept of utility. The math that is used to engineer a portfolio has been commoditized. We have computers that can do all the work no matter what asset classes we input. Pure robo-digital advisors are doing this task at low cost. The other important aspect of Markowitz’s work is the concept of utility and preference, which showed investors how to trade off risk and return on an “efficient frontier.” This is the act of determining one’s portfolio risk profile and deciding what level of risk is appropriate – where do I want to be on the efficient frontier?

Premature Optimization

The full quote at the beginning of this letter is from the renowned computer scientist Donald Knuth (Stanford) and is very applicable here: Programmers have spent far too much time worrying about efficiency in the wrong places and at the wrong times. Premature optimization is the root of all evil (or at least most of it) in programming.

Many investment advisors use Harry’s concept of the efficient frontier and diversification among asset classes to actually “overengineer” their client’s portfolios, giving them a false sense of security: “Look, here is what this cool program tells us your portfolio should look like. It’s all in the math, and that’s why you can trust it.”

This premature optimization leads people into accepting volatility in their portfolios because they think it’s required. A truer understanding of the efficient frontier is that the frontier is always moving; it’s not constant. So you can’t sit down and plan out your investment portfolio for the next 10 years in one afternoon and expect it to give you efficient, optimized results for years into the future – especially when that optimization is based on past performance and market history that is not going to be replicated in the future. Just my two cents.

This point brings to mind another great Donald Knuth quote: “Beware of bugs in the above code; I have only proved it correct, not tried it.” I can almost guarantee you that the software most investment advisors will use to show you how your portfolio should be allocated will be absolutely mathematically correct. But you will discover the bugs only as the future plays out.

Now back to my story about Harry and me.

Last year, I had an opportunity to sit outside with Harry on a fabulous California spring day, and I began again (hubris alert) to tell him why I thought Modern Portfolio Theory was going to lead investors astray, and I opined that what we needed to do was to diversify trading strategies among the various asset classes. He questioned me about how I wanted to go about doing that, and then he said, “But you are using Modern Portfolio Theory in the formulation of your strategy.” I was puzzled and was determined to figure out what he meant. He had said the same thing to me for several years, and I clearly wasn’t getting it. Our conversation continued, with me as the student and he as the very gracious and patient professor. And then the light dawned.

This is the key: I had clung to the simplistic understanding that Modern Portfolio Theory is about diversifying among noncorrelated asset classes. And it is. But I had a preconceived notion about the importance of particular asset classes. Moreover, with the correlation of all the asset classes that I understood to be in the toolbox “going to one” in times of crisis, it seemed to me that using MPT was simply diversifying your losses, not smoothing out your returns.

Harry patiently explained yet again that the key to MPT is in the words diversification and noncorrelation. The asset classes are just tools. They are interchangeable. Which was precisely what he was telling me when he was drawing those quadratic equations in the air 10 years earlier. I was just too dumb to understand. I hope that if I took his graduate course today, I could pass.

I think much of the investment industry shares my preconceived notion. Rather than opening our minds to a larger world with more potential, we assume we are limited to the asset classes most easily traded (stocks, bonds, real estate, international bonds, international real estate, large-cap, small-cap, etc.) If all you have is a hammer, everything looks like a nail.

I walked away from that conversation realizing – and have come to more firmly believe – that diversifying trading strategies is just another variant use of MPT. Call it MPT 2.0. I can still use all of the asset classes mentioned above (and, as we will see below, hundreds more), but I just don’t have to use all of them at the same time. Back in the early ’50s when Harry was writing his paper, there were numerous asset classes that didn’t correlate. International stocks and US stocks showed significantly different correlation structures and trends. Not so much anymore. Harry’s answer would be to simply change the asset classes in your toolbox and to continue to look for and find noncorrelating classes – or strategies.

Further, most “correlation studies” use past performance to predict future correlation. The sad truth is, that’s pretty much all we have available to us to determine correlation. In my study of correlation, I’ve come to understand that more is required than simply comparing historical return streams. You have to understand the underlying structure of the strategies and asset classes involved.

And that brings us to the third and final problem that will define future investing.

If You Don’t Have an Edge, There Is No Alpha

For investors, alpha is true north on the investing compass. It’s the direction you want to go.

Alpha is the positive return you get through some form of active investing, above and beyond what you would get with simple passive index investing. The theory behind active management, in most asset classes, is that managers can make a difference by using their superior analysis and systems and then putting only the best stocks (or whatever asset class they use) in their portfolios and possibly even shorting the bad ones. The theory says that the better stocks, whose earnings are rising, should go up in price more than the less profitable stocks go down.

The manager’s edge is the ability to differentiate between good companies with positive profit performance and those companies that have problems. And – this is key – for that expertise the manager gets to charge higher fees. If you were particularly good, beginning in the 1980s and through the first decade of the 2000s, you created a “long-short hedge fund” where you went “long” the stocks you thought were the better ones and “short” those you thought would fall in value. There were many different variations on this theme, but they all depended on the manager having an “edge” – some insight into true value differentiation.

But in the past few years that edge seems to have disappeared, and money has been flying out of many funds, and not just long-short funds. Active managers in the long-only space have been underperforming just as badly as their hedge fund brethren. Only about 10% of large-company mutual funds outperformed the Vanguard 500 Index Fund in the last five years.

So it’s no surprise that money is flying out of actively managed retail funds. According to CNBC, passive funds added a record $504.8 billion in 2016:

When it came to funds that focused on U.S. stocks, there was nearly a dollar-for-dollar switch:

Passive funds brought in a record $236.7 billion in investor cash, while their active counterparts saw $263.8 billion go out the door, worse even than the $208.4 billion in outflows during the height of the financial crisis in 2008. That doesn’t even count the more than $100 billion that left hedge funds during the year.

So why would that tectonic shift create problems in the valuation world? It’s simple when you think about it. Let’s take the small-cap world of the Russell 2000 as an example. My friend Paul Lyons at Tectonics went to his Bloomberg terminal and found that 30.7% of the 2000 stocks in that small-cap index had less than zero earnings for the previous 12 months, as of 3/22/17. A chart in the Wall Street Journal shows that the price-to-earnings ratio for the Russell 2000 was 81.46 as of May 26. That is not a typo.

There is $2.26 trillion in US small-cap stocks. Almost exactly 30% of that is in ETFs and mutual funds. My guess is that another 20% is in large pensions and in institutions that simply replicate the index. (Note: There are numerous small-cap indexes to choose from.)

When you buy a small index fund like the Russell 2000, even if the fees are cheap, you are buying stocks that aren’t making any money and are possibly shrinking in company size right along with those that are profitable and growing. In short, you’re buying the good and the bad indiscriminately.

And when everybody is buying every stock in the index in a massive way, there is no way for value-oriented active managers to fight that kind of buying action. They simply have no edge, or very little.

With the massive moves into passive index funds that we have seen in the past few years, shorting small-cap stocks is a prescription for pain. Yes, if a stock has seriously bad performance, it’s going to go down as stock pickers and investors sell; but finding enough such stocks to make a difference in an active fund is apparently difficult. And in the large-cap space?

Forget about it. (Note: If you have a highly concentrated portfolio, with just a few st ocks, it should be possible to outperform. But most people don’t want to take the risk of working with a manager with highly concentrated portfolios.)

So the Trump rally and the massive move into passive investing has pushed up US stocks in general (and to some extent global stocks as well). But what happens when we hit the next recession or loss of confidence? When investors start selling those passive funds, they’ll sell the good and the bad at the same time. In the case of the Russell 2000, they’ll sell all 2000 stocks. In the case of the S&P 500, all 500 stocks. And the move down has historically been much more precipitous than “climbing the wall of worry.”

How Should We Then Invest?

So let’s sum up. In my opinion, the entire world is getting ready to enter a period that I call the Great Reset, a period of enormous and unpredictable volatility in all asset classes. I believe that diversifying among asset classes will simply be diversifying your losses during the next global recession. And yet active management does not seem to be the answer because of the move by investors into passive investing. So what do we do?

I think that the answer lies in diversifying among noncorrelated trading strategies with managers who have a mandate to invest in any asset class their models tell them to. For a reasonably sophisticated investment professional, there are any number of ways to diversify trading strategies.

Up to this point in this letter, I’ve been talking philosophy rather than telling you how I actually intend to go about investing. In the coming paragraphs I’ll tell you how I’m going to diversify trading strategies and give you a link to the actual strategies, performance history, and managers that I will be using. Some of you will not agree with the philosophy I outlined above; some of you will think you can do a better job (or at least a different one) of diversifying trading strategies and managing money.

But, putting on my entrepreneurial business hat, my hope is that some of you will join me.

Back in the day, I allocated money to asset managers who traded mutual funds, before the rules were changed to make active trading of mutual funds either illegal or extremely difficult. But with the growth of money in exchange-traded funds (ETFs), that has changed. Globally, there is about $3.8 trillion in ETFs today. There are almost 2000 ETFs in the US alone, and according to ETFGI there are 4,874 ETFs globally, whose assets have skyrocketed from $807 billion in 2007 to $4 trillion today.

You know how somebody will talk about getting a time-consuming task done and then the next person says, “There’s an app for that”? No matter what asset you want, there’s now an ETF for that. I am constantly amazed how narrowly focused ETFs can be. There is now an ETF that focuses its investments just on companies in the ETF industry. It’s not all large-cap-index ETFs anymore. Some really small, niche-market ETFs have attracted significant capital.

Not surprisingly, a growing number of asset managers actively trade ETFs using their own proprietary systems. I began searching for the best of them some three years ago. I soon realized, for reasons I will explain in a white paper, that a combination of several managers is much better than just one. I have assembled a portfolio of four active ETF asset managers/traders with radically different styles. That approach theoretically gives me the potential for much less volatility than each manager’s system would face individually. The combination I’ve put together has been less volatile historically than the markets, over a full cycle.

Part of my edge is that I have been in the “manager of managers” business for more than 25 years, looking at hundreds of investment managers and strategies. That has actually been my day job when I’m not writing. So when a manager explains his system to me, I can “see” how it fits with those of other managers, understand whether it is truly different, and finally, determine whether it would add any benefit to my total mix. I’ve also learned that having more than the optimal number of managers doesn’t necessarily improve overall performance, but it does add complexity and increase trading costs.

You’re dealing with a few new puzzle pieces analyst,

John Mauldin

Wall Street's Best Minds

Grantham: Don’t Expect P/E Ratios to Collapse

Jeremy Grantham writes that era of high profit margins has contributed to stubbornly high multiples.

By Jeremy Grantham

Oh, the good old days!

 

When I started following the market in 1965 I could look back at what we might call the Ben Graham training period of 1935-1965. He noticed financial relationships and came to the conclusion that for patient investors the important ratios always went back to their old trends.

He unsurprisingly preferred larger safety margins to smaller ones and, most importantly, more assets per dollar of stock price to fewer because he believed margins would tend to mean revert and make underperforming assets more valuable.

 

 

You do not have to be an especially frugal Yorkshireman to think, “What’s not to like about that?”

So in my training period I adopted the same biases. And they worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next! ¹ Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually – inconveniently, sometimes a couple of painful years longer than expected – they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.

Exhibit 1 shows what happened to the average P/E ratio of the S&P 500 after 1996. For a long and painful 20 years – for someone betting on a steady, unchanging world order – the P/E ratio stayed high by 1935-1995 standards. It still oscillated the same as before, but was now around a much higher mean, 65% to 70% higher! This is not a trivial difference to investors, and 20 years is long enough to test the apocryphal but suitable Keynesian quote that the market can stay irrational longer than the investor can stay solvent.

Along the way there were early signs that things had changed. First was the decline from the greatest bubble in US equity history, the 2000 tech bubble. Compared to the previous high of 21x earnings at the 1929 bubble high, this 2000 market shot up to 35x and when it finally broke, it fell only for a second to touch the old normal price trend. And then it quite quickly doubled.

Compare that experience to the classic bubbles breaking in the US in 1929 and 1972 (Exhibit 2) or Japan in 1989. All three crashed through the existing trend and stayed below for an investment generation, waiting for a new crop of more hopeful investors. The market stayed below trend from 1930 to 1956 and again from 1973 to 1987. And in Japan, the market stayed below trend for… you tell me. It is 28 years and counting! Indeed, a trend is by definition a level below which half the time is spent. Almost all the time spent below trend in the US was following the breaking of the two previous bubbles of 1929 and 1972. After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months. So, we have actually spent all of six months cumulatively below trend in the last 25 years! The behavior of the S&P 500 in 2002 might have been whispering in my ear, but surely this is now a shout? The market has been acting as if it is oscillating normally enough but around a much higher average P/E.

How about profit margins, the other input into the market level? Exhibit 3 shows the return on sales of the S&P 500 and Exhibit 4 shows the share of GDP held by corporate profits. Compared to the pre- 1997 era, the margins have risen by about 30%. This is a large and sustained change. And remember, it is double counting: above-average profit margins times above-average multiples will give you very much above-average price to book ratios or price to replacement cost. Counterintuitively, if we need to sell at replacement cost (most people’s view of fair value), then above-normal margins must be multiplied by a below-average P/E ratio and vice versa.

 

To this point, we have looked at two of the three most important inputs in markets and they are very different in the same direction, upwards. A third one – interest rates – is also very different. As is wellknown, short rates have never been at such low levels in history as they were last year. Come to think of it, the population growth rate is also very, very different. As is the aging profile of our population. And the degree of income inequality. So too the extent of globalization and indicators of monopoly in the US. Also the extended period of below-trend GDP growth and productivity almost everywhere but particularly in the developed world. And serious climate change issues that may be understated in countries like the US, the UK, and Australia, where the fossil fuel industries are powerful and engage in effective obfuscation, but pre-1997 the topic was not broadly appreciated at all. The price of oil in 1997 was more or less on its 80-year trend in real terms of around $18 a barrel in today’s currency. The trend price today, based on the cost of finding new oil, is about $65 a barrel with today’s price only slightly lower despite an unexpected surge in supply from US tight oil, or fracking. Three and a half times the old price is not an insignificant change when you realize that almost all serious economic declines have been associated with price surges in oil.

And, finally, my old bugbear – the modus operandi of the Federal Reserve and its allies is very different in its 22-year persistent effort to work the highs and lows of the rate cycle lower and lower. One might ask here: Is there anything that really matters in investing that is not different? (Actually, I have one, but will save it for another discussion: human behavior.)

We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “This time is different.”2 For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.

 

Corporate profitability is the key difference in higher pricing  

Of all these many differences, the most important for understanding the stock market is, in my opinion, the much higher level of corporate profits. With higher margins, of course the market is going to sell at higher prices. So how permanent are these higher margins? I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997. So why did they stop mean reverting around the old trend? Or alternatively, why did they appear to jump to a much higher trend level of profits? It is unreasonable to expect to return to the old price trends – however measured – as long as profits stay at these higher levels.

So, what will it take to get corporate margins down in the US? Not to a temporary low, but to a level where they fluctuate, more or less permanently, around the earlier, lower average? Here are some of the influences on margins (in thinking about them, consider not only the possibilities for change back to the old conditions, but also the likely speed of such change):

 

• Increased globalization has no doubt increased the value of brands, and the US has much more than its fair share of both the old established brands of the Coca-Cola and J&J variety and the new ones like Apple,  Amazon, and Facebook. Even much more modest domestic brands – wakeboard distributors would be a suitable example – have allowed for returns on required capital to handsomely improve by moving the capitalintensive production to China and retaining only the brand management in the US. Impeding global trade today would decrease the advantages that have accrued to US corporations, but we can readily agree that any setback would be slow and reluctant, capitalism being what it is, compared to the steady gains of the last 20 years (particularly noticeable after China joined the WTO).

 

• Steadily increasing corporate power over the last 40 years has been, I think it’s fair to say, the defining feature of the US government and politics in general. This has probably been a slight but growing negative for GDP growth and job creation, but has been good for corporate profit margins. And not evenly so, but skewed toward the larger and more politically savvy corporations. So that as new regulations proliferated, they tended to protect the large, established companies and hinder new entrants. Exhibit 5 shows the steady drop of net new entrants into the US business world – they have plummeted since 1970! Increased regulations cost all corporations money, but the very large can better afford to deal with them. Thus regulations, however necessary to the well-being of ordinary people, are in aggregate anti-competitive. They form a protective moat for large, established firms. This produces the irony that the current ripping out of regulations willy-nilly will of course reduce short-term corporate costs and increase profits in the near future (other things being equal), but for the longer run, the corporate establishment’s enthusiasm for less regulation is misguided: Stripping out regulations is working to fill in its protective moat.

• Corporate power, however, really hinges on other things, especially the ease with which money can influence policy. In this, management was blessed by the Supreme Court, whose majority in the Citizens United decision put the seal of approval on corporate privilege and power over ordinary people. Maybe corporate power will weaken one day if it stimulates a broad pushback from the general public as Schumpeter predicted. But will it be quick enough to drag corporate margins back toward normal in the next 10 or 15 years? I suggest you don’t hold your breath.

• It is hard to know if the lack of action from the Justice Department is related to the increased political power of corporations, but its increased inertia is clearly evident. There seems to be no reason to expect this to change in a hurry.

• Previously, margins in what appeared to be very healthy economies were competed down to a remarkably stable return – economists used to be amazed by this stability – driven by waves of capital spending just as industry peak profits appeared. But now in a very different world to that described in Part 1,4 there is plenty of excess capacity and a reduced emphasis on growth relative to profitability. Consequently, there has been a slight decline in capital spending as a percentage of GDP. No speedy joy to be expected here.

• The general pattern described so far is entirely compatible with increased monopoly power for US corporations. Put this way, if they had materially more monopoly power, we would expect to see exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations; and fewer new entrants into the corporate world and a declining number of increasingly large corporations. And because these factors affect the US more than other developed countries, US margins should be higher than theirs. It is a global system and we out-brand them for one thing.

• The single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average, leaving them a mere 6% higher. (Turning up the rate dial just another 0.5% with a further modest reduction in leverage would push them to complete the round trip back to the old normal.)

This neat outcome tempted me to say, “well that’s it then, these new higher margins are simply and exclusively the outcome of lower rates and higher leverage,” leaving only the remaining 20% of increased margins to be explained by our almost embarrassingly large number of other very plausible reasons for higher margins such as monopoly and increased corporate power.

But then I realized that there is a conundrum: In a world of reasonable competitiveness, higher margins from long-term lower rates should have been competed away. (Corporate risk had not materially changed, for interest coverage was unchanged and rate volatility was fine.) But they were not, and I believe it was precisely these other factors – increased monopoly, political, and brand power – that had created this new stickiness in profits that allowed these new higher margin levels to be sustained for so long.
 
So, to summarize, stock prices are held up by abnormal profit margins, which in turn are produced mainly by lower real rates, the benefits of which are not competed away because of increased monopoly power, etc. What, we might ask, will it take to break this chain? Any answer, I think, must start with an increase in real rates.

Last fall, a hundred other commentators and I offered many reasons for the lower rates. The problem for explaining or predicting future higher rates is that all the influences on rates seem long term or even very long term. One of the most plausible reasons, for example, is the aging of the populations of the developed world and China, which produces more desperate 50-yearolds saving for retirement and fewer 30-year-olds spending everything they earn or can borrow. This results, on the margin, in a lowered demand for capital and hence lower real rates. We can probably agree that this reason will take a few decades to fade away, not the usual seven-year average regression period for financial ratios.

 

Any effect of lower population growth rates is likely to take even longer. No one seems sure what is causing lower productivity growth or what role it has in lower rates, but it would take some very unexpected good fortune to have productivity accelerate enough to drive rates upward in the near term. Income inequality that may be helping to keep growth and rates lower will, unfortunately, in my opinion, also take decades to move materially unless we have a very unexpected near revolution in politics.

Perhaps the best bet for higher rate equilibrium in the next few years is a change in the dominant central bank policy of using low rates to stimulate asset prices (which they clearly do) and stimulate growth (which, other than pushing growth back or forward a quarter or so, I believe they do not do). With 20 years of Fed support for this approach and loyal adherents in the ECB and The Banks of England and Japan, changing the policy is unlikely to be quick or easy. It is a deeply entrenched establishment view, or so it seems.

President Trump is admittedly a very, very wild card in this game, and he said a few anti-Fed things in the election phase, for whatever that is worth. He also gets to appoint five new members, including the chair, in the next 18 months. But in the end, will a real estate developer with plenty of assets and an apparent interest in being very rich really promote a materially higher-yield policy at the Fed? Possible, but quite improbable, I think. In short, I think lower rates than those in effect pre-1997 are likely to be with us for years, and the best we can hope for is several of the factors we’ve discussed moving slowly to push real rates higher.

In the meantime, while we wait for higher risk-free rates, investors – value mangers included – should brace themselves for continued higher multiples than those of the old days.

(Although with a very good chance that multiples will show a very slow decline.)

What does this mean for value investing? What it does not mean is that cheaper is not better. But price to book was never a measure of cheapness. The low price to book ratios reflect the market’s vote as to which companies have the least useful assets.

Only if the market gets carried away with pessimism or feels uncomfortable with the career risk of owning companies in temporary trouble will such ratios work. Sometimes they do and sometimes they don’t. A fully-fledged dividend discount model with strong quality adjustments and epic struggles to correct for accounting slippage is ideally what is needed. Alternatively, any analyst good enough to predict the future, whether for six months or six years, better than the market will win.

Unfortunately for us investors, the prediction business is not easy. The S&P has been selling at a much higher level of P/E for 20 years now and it has not meant that better stock pickers have not won. My personal belief and experience has been, though, that the greatest deviations from fair value occur at more macro levels – countries and asset classes – where career risk is higher than picking one insurance company over another and therefore the inefficiencies and opportunities for outperforming are greater.

What this argument probably does mean is that if you are expecting a quick or explosive market decline in the S&P 500 that will return us to pre-1997 ratios (perhaps because that is the kind of thing that happened in the past), then you should at least be prepared to be frustrated for some considerable further time: until you can feel the process of the real interest rate structure moving back up toward its old level.

All in all, from the many possibilities, I prefer my suggestion (from Part 1) of a 20-year limping regression that takes us two-thirds of the way back to the good old days pre-1997. What I fear is that if I am wrong, it is less likely to be because regression is more dramatic as some die-hard value managers believe (and I would dearly, dearly love to see!) than it is to be even slower. (The outlook I proposed for the S&P 500 last October of 2.8% real per year for 20 years – the whimper path – has fallen to 2.3% real at recent higher prices).

 

Outlook for corporate margins – and hence (probably) the market in 2017

 

There are three factors moving in favor of US profit margins this year. First, oil and resource prices appeared to have bottomed out last year and seem likely to have favorable comparisons for a few quarters.

Second, Trump is likely to settle for a moderate reduction in corporate tax rates this year after bouncing off the infinitely complex task of a full redo of the tax code. In a theoretical world, corporate taxes are a pass-through to consumers, but in the current, stickier, more monopolistic, more profit-fixated world, a corporate tax reduction will raise corporate profits for quite a while from where they otherwise would have been. Third, removing regulations here and there will, as mentioned, lower corporate costs in the short term.

Net-net, unless there are some substantial unexpected negatives, US corporate margins will be up this year, making for the likelihood, in my opinion, of an up year in the market at least until late in the year. This does seem to make the odds of a major decline in the near future quite low (famous last words?). Next year, though, is a different proposition. In conclusion, there are two important things to carry in your mind: First, the market now and in the past acts as if it believes the current higher levels of profitability are permanent; and second, a regular bear market of 15% to 20% can always occur for any one of many reasons. What I am interested in here is quite different: a more or less permanent move back to, or at least close to, the pre-1997 trends of profitability, interest rates, and pricing. And for that it seems likely that we will have a longer wait than any value manager would like (including me).


Jeremy Grantham is the co-founder of GMO, a Boston-based asset management firm. Grantham is the firm’s chief investment strategist.

How Japan is preparing for a nuclear attack
     
‘Few US voters realise that American troops in Japan or even California might be a target for a missile strike’

by: Gillian Tett




Earlier this month, I travelled to Tokyo, where I caught up with some Japanese friends. As we chatted about global affairs, one of them, Michiyo, revealed that her doctor husband had recently given her anti-radiation pills to carry in her handbag.

The reason? Not the leak of radioactive material that occurred at the Fukushima nuclear plant after it was hit by a tsunami six years ago. Instead, what worries Michiyo’s husband is North Korea.

In recent months, the secretive country has conducted an escalating series of missile tests, including one just last week. This has sparked fears among western intelligence services that Pyongyang could be close to acquiring an inter-continental ballistic missile with the ability to deliver nuclear warheads to places such as Japan, Guam, Hawaii or even California.T

here are reports that North Korea has mastered several of the crucial stages for creating an ICBM: the ability to launch and guide a missile, create a nuclear warhead and then miniaturise it. Meanwhile tensions have risen between the unpredictable regime of Kim Jong-un and the (sometimes equally unpredictable) US president Donald Trump, prompting speculation that North Korea might try to direct a missile at a US base in Japan.

The Japanese government has responded by issuing guidelines for what to do in the event of a missile strike. Suggestions include sheltering in an underground shopping arcade, basement, concrete building or, if all else fails, under a table or in a cupboard in the centre of the house, for at least two days, presumably to let any fallout from an attack settle down.

Many Japanese households have duly been stocking up on food, water, batteries, nappies (which might be needed to stand in for toilets, my friends solemnly told me) and those anti-radiation tablets. Company executives have prepared backup offices, financial institutions have spread money in different locations and utility services and schools have conducted drills. Indeed, while I was in Tokyo the trains briefly shut down following one of North Korea’s missile tests.

I hope that in a few years’ time these drills will simply look like an overreaction, a quaint historical curiosity, comparable to moves that the US government took to prepare for a Soviet nuclear attack during the cold war (back then people were also told to hide in a cupboard).

Nobody has a clue whether Pyongyang could or would ever dare fire a missile, or whether the Americans possess the ability to intercept it. Foreign policy observers still think an attack is very unlikely. But what is striking about all these preparations in Japan is not that they are occurring but that so few people in the US or Europe know about them. That is partly because the North Korean threat has largely stayed below the surface, at least in the public consciousness.

***

One of the US’s biggest business groups, for example, polls its members each quarter about how company executives perceive geopolitical risks. Until very recently, a minute proportion of companies considered North Korea to be the most serious threat; instead, the dominant focus for concern was so-called Islamic State.

Yet the pattern is changing. In the most recent survey, compiled this month, North Korea is ranked as the number one threat, above Isis. But most voters still know little about the country, and few realise that American troops in Japan or California might be a target.

A second reason why the preparations are not better known is that the Japanese public are themselves notably stoic. If the White House had told voters to buy supplies for a possible missile attack, the news would have ricocheted around the world. But most Japanese have simply acquired supplies as suggested and got on with their lives with a minimum of fuss.

That might seem peculiar to Americans. But Japanese people have lived with the knowledge that North Korea could fire a missile towards them for many years. And, of course, they have also weathered earthquakes. Confronting a possible missile threat looks scary but it’s not necessarily any more frightening than the knowledge that more than 33,000 people are killed by gunfire each year in the US. Cultural perceptions of danger vary.

But the next time I see Trump talk or tweet about North Korea, I will think about my friend’s anti-radiation pills. The fact that she is now carrying them in her wallet is a tragic sign of how peculiar the world has become. I just hope that she will never even have to think about using them.

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