Tuesday, September 22, 2009 5 comments

Thoughts on Jim Grant's change into bull costume

(source: Mick Coulas for The Wall Street Journal)

Most of you may have seen The Wall Street Journal article by Jim Grant, where he morphs from a bear into a bull. Surprising to some perhaps. I thought I would post my views (made on a GuruFocus message board) on his opinion piece.

Jim Grant isn't just any other bear. The fact that he is bullish is big news, at least to me.

However, it's not clear to me if he is bullish on assets like stocks and bonds, or if he is bullish on the economy. The two, as historians would know, are not correlated (for example, the economy actually did quite well in the 70's but the stock market did not; conversely, the stock market did well from 1932 to, say, 1938, but the economy did not.)

If he is turning bullish on stocks, I think he may be a bit late to be riding the bulls and I would bet against him. But if he expecting a strong economy, he may turn out to be right (although I'm still not convinced.)

The way I look at it, the forecasts come down to whether you believe in Keynesian Economics or Austrian Economics. Jim Grant, being the Austrian persuation, is saying that interest rates are too low, and likely at negative real rates, so it makes sense to expect booms. Keynesian-types, in contrast, seem to suggest that we have hit a liquidity trap and interest rates may even be too high. I lean more towards the latter, which is more consistent with my tilt towards deflation.

It remains to be seen what actually materializes. Nearly all assets--stocks, bonds, emerging markets, real estate, commodities--have rallied but I'm not sure that it due to negative real rates. Instead, it appears to be driven by fiscal spending (especially in China and USA, but in other countries as well.) The real test is what happens when fiscal stimulus dissapears.

The amazing thing to me is that long-term bond yields remain low. I don't know if the FedRes monetization has anything to do with this, but if we just take the signal for what it is, it may be important. The ultimate issue is still the inflation vs deflation question and the bond market seems to be betting against other assets. Bonds are generally thought to be more correct than stocks but that hasn't been the case this year. The super-high default rates forecast by the bond market early in the year is nowhere to be found.


5 Response to Thoughts on Jim Grant's change into bull costume

September 25, 2009 at 5:21 AM

From a macro perspective, there is an intriguing fact which does not receive much attention, and yet could be significant from a long term of view.

The US economy has grown at about 6% (nominal) since almost forever. Yet, from around 2000 it has slowed to circa 5%, and the CBO even projects a further reduction to 4% the next decade. Now, one can argue that this change is significant, or one could think of this as a blip, some form of noise which will correct itselft in the next decades. If you believe the latter, as I am inclined to do, there is room for additional long-term growth, not accounted for in the present estimates.

To have an idea of what we are talking about, compare the estimate of US GDP for 2019:
-CBO: 21320
-growth of 6% from 2000: 28625
Around 1/3 larger! Admitted, this nominal growth could be just inflation (a likely result in the longer term), but I would not neglect this upward pressure on GDP in a macro analysis. This does not contradict the existence of serious short-term deflationary trends, but a long-term investor could (should?) think two moves ahead of the market, rather than one. He might have an edge there.

Incidentally, the total market capitalization has historically been above 60% of GDP. At 2019, 60% of the GDP trend is an S&P 500 of about 1700, which turns to be in line with Buffett's famous puts. And I would not bet against Buffett's long-term wisdom.

September 25, 2009 at 5:53 AM

To complement the point on Buffett's puts, there is the additional thought that, even though the S&P 500 is below the strike price at exercise, and money would have to be lost, the corresponding set of conditions very likely indicate a good long-term buying opportunity in the stock market. A win-win for Berkshire, I would say.

And the second point I did not mention is that this hypotetical growth to trend GDP, either via inflation or via real growth, is quite likely to be the way our current government debt is worked out.

Sivaram Velauthapillai
September 25, 2009 at 11:01 AM

Lower GDP growth in the next decade is very likely in my opinion. A lot of the GDP was fuelled by debt and if debt contracts then the growth may not be so good. The question is whether this takes 10 years or keeps going on for 20+ years like Japan (although part of Japan's problem is demographics.)

Comparing very-long-term growth is also a bit dicey IMO. USA was basically an emerging market in the late 1800's and, to some degree, early 1900's. Then it was like a rocket ship with the development into a fully developed economy after the 1940's. Although the demographics look better than most other countries, it's still hard to see growth rates anywhere like the past 100 years. I don't know if nominal growth will average 4%--that looks a bit low--but I think 4.5% to 5% looks more reasonable.

As you point out, due to compounding, small differences can end up producign a huge difference over a decade or more. So it's a bit dangerous to rely solely on this.

Anyway, the thing we need to keep in mind is that the stock market is not correlated very well with the economy. So as an investor, the economic picture may be almost irrelevant. For instance, even if we hit the high end of the GDP growth, if corporate profit margins fall, stocks will likely perform poorly.

Sivaram Velauthapillai
September 25, 2009 at 11:07 AM

I think Buffett's puts were a mistake. The appear to be written almost right near the ultimate top. If we get high inflation the puts will work out but otherwise it's not such a great bet. I think Buffett would say the same thing, although he wouldn't publicly admit it yet. However, Buffett is very conservative with his estimates so he will probably break-even. It'll be kind of like his investment in US Air, an airline, which was a terrible investment but somehow he managed to pull out a save. I don't know what the break-even value is but as long as he earns probably 5% or more on the put premiums (which is quite doable) and stock indices don't fall completely off a cliff, he will probably break even.

Sivaram Velauthapillai
September 25, 2009 at 11:20 AM

Zitron: "And the second point I did not mention is that this hypotetical growth to trend GDP, either via inflation or via real growth, is quite likely to be the way our current government debt is worked out."

Yep. I'm not concerned about the US government debt. It isn't very high and as long as economic growth is decent, it isn't an issue. A lot of countries run into debt problems because (i) it is issued in a foreign currency, or (ii) their economies are really weak. None of this applies here. As long as USA is free-market-oriented, it'll be fine.

As for paying it off via inflation, I think that is unlikely. Many argue that the US govt will inflate away its debt but it will wreck its economy. Many countries who inflate are developing countries who don't care about their economy (because they are quasi-dictatorships or kleptocracies with elites completely shielded from the side-effects) or very few of the financial assets (like bonds) are owned by the citizens (in developing and poor countries, bonds are mostly owned by wealthy and foreigners--this is one reason there is the mentality to "screw the bondholders")...

Furthermore, people who think inflating away the debt is feasible never seem to tackle the impact on future debt issuance. If the bond market detects inflation it will sell off the debt (i.e. yields will rise) and the govt will end up paying even more in the future. In other words, as long as the govt has to continuously re-finance its maturing debt, it is difficult to inflate.

Having said that, the US govt will have to cut certain "optional" obligations related to pensions, healthcare, so-called social security, and the like. If you include these "optional" obligations then the debt is extremely large and possibly unmanageable.

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