Fw: Why Bother With Bonds? - John Mauldin's Weekly E-Letter

 

From: John Mauldin

Sent: Saturday, March 28, 2009 10:59 AM

To: jmiller2000@verizon.net

Subject: Why Bother With Bonds? - John Mauldin's Weekly E-Letter

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Thoughts from the Frontline Weekly Newsletter Why Bother With Bonds? by John Mauldin March 28, 2009
In this issue: Why Bother With Bonds? So Then, Bonds for the Long Run? P/E Ratios at 200? Really? Mark-to-Market Slip Slides Away Housing Sales Improve? Not Hardly La Jolla, Copenhagen, London, etc.
Investors, we are told, demand a risk premium for investing in stocks rather than bonds. Without that extra return, why invest in risky stocks if you can get guaranteed returns in bonds? This week we look at a brilliantly done paper examining whether or not investors have gotten better returns from stocks over the really long run and not just the last ten years, when stocks have wandered in the wilderness. This will not sit well with the buy and hope crowd, but the data is what the data is. Then we look at how bulls are spinning bad news into good and, if we have time, look at how you should analyze GDP numbers. Are we really down 6%? (Short answer: no.) It should make for a very interesting letter. And for the last time, let me remind you of the Richard Russell Tribute Dinner this Saturday, April 4 in San Diego. We have had over 400 of Richard's fans (I guess you could say we are all groupies) sign up. A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. You are going to be able to rub shoulders with some very famous analysts and writers. If you are a fellow writer, you should make plans to attend or send me a note that I can put in the tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven't, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don't procrastinate. I wouldn't want any of you to miss out on this tribute. I look forward to sharing the evening with all of you. I am really looking forward to that evening. Why Bother With Bonds? If stocks outperform bonds by as much as 5% over the long run then, for our truly long-term money, why should we bother with bonds? Why not just ignore the volatility and collect the increased risk premium from stocks? That is the message of those who believe in "Stocks for the Long Run" and also from those who want you to invest in their long-only mutual fund or managed account program. Indeed, it is always a good day to buy their fund. One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of Research Affiliates, out of Newport Beach, California, a research house which is responsible for the Fundamental Indexes which are breaking out everywhere (and which I have written about in past letters), as well as the only outside manager that PIMCO uses, for his asset allocation abilities. He has won so many industry awards and honors that I won't take the time to mention them. In short, Rob is brilliant. He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled "Bonds: Why Bother?" The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will be available when the Journal of Indexes goes to print in late April, at www.journalofindexes.com. Qualified financial professionals can also get a free subscription there to pick up the print copy. There is some very interesting research at the website. But let's look at a small portion of the essay. I am reducing 17 pages down to a few, so there is a lot more meat than I can cover here, but I will try and hit a few things that really struck me. It is written into our investment truisms that investors expect their stock investments to outpace their bond investments over really long periods of time. Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5% risk premium over bonds. By "risk premium," we mean the forward-looking expected returns of stocks over bonds. As noted above, if you do not think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That "reasonable margin" is called the risk premium, about which there is some considerable and heated debate. Most people would consider 40 years to be the "long run." So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium. In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is at best unreliable and is probably little more than an urban legend of the finance community. How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the '70s. Let's go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds. Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the 19th century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009. In fact, note that stocks only marginally beat bonds for over 90 years in the 19th century. (Remember, this is not a graph of stock returns, but of how well stocks did or did not do against bonds. A chart of actual stock returns looks much, much better. Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19th century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%. In the late '90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20th century. The 19th century for them was meaningless, as the stock market then was small, and we were now in a modern world. But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use. So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes: "My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history's 2.5 percentage point excess return or the five percent premium that most investors expect? "As Peter Bernstein and I suggested in 2002, it's hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day." One other quick point from this paper. Just as capitalization-weighted indexes will tend to emphasize the larger stocks, many bond indexes have the same problem, in that they will overweight large bond issuers. At one point in 2001, Argentina was 20% of the Emerging Market Bond Index, simply because they issued too many bonds. If you bought the index, you had large losses. The same with the recent high-yield index which had 12% devoted to GM and Ford. In general, I do not like bond index funds, and this is just one more reason to eschew them. So Then, Bonds for the Long Run? Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs (it will be a challenge for my Chinese translator to translate that pun!). Very often, they are designed with biases within them that may not even be apparent to the person who created them. Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, "I have students of mine - PhDs - going around the country telling people it's a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe." When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something. As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market. Valuations matter, as I wrote for many chapters in Bull's Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now? I have been doing a lot of interviews with the press, with them wanting to know if I think this is the start of a new bull market. There are a lot of pundits on TV and in the press who think so. I also notice that many of them run mutual funds or long-only investment programs. What are they going to do, go on TV and say, "Sell my fund"? And get to keep their jobs? Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias that points them to the positive news that would make their fund (finally!) perform. And believe me, I can empathize. It is part of the human condition. But you just need to keep that in mind when you are thinking about investing in a new fund, or rethinking your own portfolio. P/E Ratios at 200? Really? Just for fun, when I was interviewing with the New York Times today, I went to the S&P web site and looked at the earnings for the S&P 500. It's ugly. The as-reported loss for the S&P 500 for the 4th quarter was $23.16 a share. This is the first reported quarterly loss in history. That almost wipes out the expected earnings for the next three quarters. For the trailing 12 months the P/E ratio, as of the end of the second quarter, is 199.97. Close enough to 200 for government work. But it gets worse. The expected P/E ratio for the end of the third quarter is (drum roll, please) 258! However, taking the loss of the fourth quarter off the trailing returns allows us to get back to an estimated P/E of 23 by the end of 2009. The problem is that you have to believe the estimates, which I have shown are repeatedly being lowered each quarter, and which I expect to be lowered by at least another 25% in the coming months. Now, much of that loss is coming from the financials, which showed staggering write-offs of $101 billion, $28 billion coming from (no surprise) AIG alone. Sales across the board are down almost 9%, with 290 companies reporting lower sales. This quarter the estimated consensus GDP is somewhere between down 5% to down 7%. Last quarter we were down an annualized 6.3%. That would be two ugly quarters back to back. It is hard to believe earnings for nonfinancial companies are going to be all that much better. Side note: The economy did not contract at 6.3% in the 4th quarter. That is an annualized number. The quarter actually contracted at about 1.6%. If we go a whole year with a 6% contraction, that would be truly horrendous. We would blow right on through 10% unemployment. While it is possible, we should start to see somewhat better numbers in the second half of the year, although I still think they will be negative. Mark-to-Market Slip Slides Away But it is quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) changed the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of "temporary" impairments of troubled assets, which will "allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses." (www.gavekal.com) Here's the important part. The board decided to make the new changes effective immediately, prior to full board approval on April 2. As my friend Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer money at risk. Expect to see a pop in valuations. It will be interesting to see if Citi and B of A post profits this quarter. (I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so fortunate as their US counterparts.) In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand that this is a very controversial proposal, and I expect many readers will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place. This could put some strength back into financials, at least until the commercial mortgage and credit card problems start having to be written off. At the least, it could make for another solid rise in the stock market until we start to get what I expect to be very bad 1st and 2nd quarter earnings. Housing Sales Improve? Not Hardly I opened the Wall Street Journal and read that new home sales were up in February. Bloomberg reported that sales were "unexpectedly" up by 4.7%. I was intrigued, so I went to the data. As it turns out, sales were down 41% year over year, but up slightly from January. But if you look at the data series, there was nothing unexpected about it. For years on end, February sales are up over January. It seems we like to buy homes in the spring and summer and then sales fall off in the fall and winter. It is a very seasonal thing. If you use the seasonally adjusted numbers, you find sales were down 2.9% instead of up 4.7%. But the media reports the positive number. Interestingly, they report the seasonally adjusted numbers for initial claims, which have been a lot better than the actual numbers. Not that they are looking to just report positive news, you understand. Plus, as my friend Barry Ritholtz points out, the 4.7% rise was "plus or minus 18.3%". That means sales could have risen as much as 23% or dropped 13%. We won't know for awhile until we get real numbers and not estimates. Hanging your outlook for the economy or the housing market on one-month estimates is an exercise in futility, and could come back to embarrass you. But that brings up my final point tonight, and that is how data gets revised by the various government agencies. Typically with these government statistics, you get a preliminary number, which is a guess based on past trends, and then as time goes along that data is revised. In recessions like we are in now the revisions are almost always negative. There is no conspiracy here. The people who work in the government offices have to create a model to make estimates. Each data series, whether new home sales, employment, or durable goods sales, etc., has its own unique sets of characteristics. The estimates are based on past historical performance. There is really no other way to do it. So, past performance in a recession suggests higher estimates than what really happens. Then, the numbers in the following months are revised downward as actual numbers are obtained. But the estimates in the current months are still too high. That makes the comparisons generally favorable, at least for one month. And the media and the bulls leap all over the "data," and some silly economist goes on TV or in the press and says something like, "This is a sign that things are stabilizing." It drives me nuts. Ignore month-to-month estimated data. The key thing to look for is the direction of the revisions. If they are down, as they have been for over a year, then that is a bad sign. Further, one month's estimates are just noise. Look at the year-over-year numbers. When the direction of the revisions is positive and the year-over-year numbers are starting to stabilize, then we will know things are starting to turn around. La Jolla, Copenhagen, London, etc. April is a travel month. Next week I am going to a presentation in Irvine on the state of stem cell research, which I must admit fascinates me. Then I'm in La Jolla for my Strategic Investment conference, co-hosted with my partners Altegris Investments. Then home for a week. Easter weekend, all seven kids will be home. Then the next week I go to Copenhagen for a board meeting; and I will be in London, Thursday April 16 to meet with my European partners, Absolute Return Partners, and clients. The next weekend I go back to California for a conference, and then the next week I'll be a day or so in Orlando, where I'll speak at the CFA conference on the state of the alternative investment industry. While I'm in London, I need to drop by and buy a pint for David Stevenson, a columnist for the Financial Times. Seems that he was asking his readers for nominations for best financial websites. For whatever reason, he decided I deserved a special award: "Best online commentator goes to US analyst John Mauldin, whose weekly letters at www.frontlinethoughts.com are required reading for all the big City-based bears I encounter." It's nice to be appreciated. At the end of May (29-31), I will be in Naples, where I will be doing a seminar with Jyske Global Asset Management and Gary Scott. I will try to line up a web site where you can see whether you would like to attend. It's after midnight and time to hit the send button. The day simply vanished on me, although I did get to the gym, at least. I am working hard, but somebody turned the dial down on my metabolism. Have a great weekend. It is spring in the northern hemisphere, and the azaleas in Texas are awesome this year. Make sure you stop and enjoy nature a little this spring (or fall, for you blokes Down Under). Your getting more skeptical of data as I get older analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 John Mauldin. All Rights Reserved Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.
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You have permission to publish this article electronically or in print as long as the following is included: John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore To subscribe to John Mauldin's E-Letter please click here: http://www.frontlinethoughts.com/subscribe.asp To change your email address please click here: http://www.frontlinethoughts.com/change.asp If you would ALSO like changes applied to the Accredited Investor E- Letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com To unsubscribe please refer to the bottom of the email. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. John Mauldin is also president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of John Mauldin. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to jmiller2000@verizon.net Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

Fw: Roadmap To Inflation And Sources Of Cheap Insurance - John Mauldin's Outside the Box E-Letter

 

From: John Mauldin and InvestorsInsight

Sent: Tuesday, March 24, 2009 12:52 PM

To: jmiller2000@verizon.net

Subject: Roadmap To Inflation And Sources Of Cheap Insurance - John Mauldin's Outside the Box E-Letter

	Contact John Mauldin Print Version Volume 5 - Issue 22 March 24, 2009 Roadmap To Inflation And Sources Of Cheap Insurance by James Montier What happens when inflation once again returns. As this week's Outside the Box writer, James Montier, writes, we may want to start thinking now about inflation insurance and he mentions a few ways to do so. But this letter is a must read for his bringing to light a speech by Fed chairman Ben Bernanke in 2000 given to the Japanese, where he suggest inflation targeting: "In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!" I think you will find this week's OTB to be exceptionally thought provoking. Montier is one of my favorite economic thinkers (and a good friend). He works for Societe Generale in London in their Cross Asset Research group. John Mauldin, Editor Outside the Box ADVERTISEMENT Roadmap To Inflation And Sources Of Cheap Insurance by James Montier As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions. In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction. Fisher and the debt-deflation theory of depressions In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher's "The debt-deflation theory of Great Depressions" published in 19331. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex. In his debt-deflation theory, he posits "two dominant factors" in driving depressions "Namely over-indebtedness to start with and deflation following soon after... In short, the big bad actors are debt disturbances and price-level disturbances". He continues "Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed." That is to say, debt-deflation spirals can easily become self-reinforcing. The good news is that Fisher is also very clear on how to end a debt-deflation spiral: "It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors... I would emphasize... that great depressions are curable and preventable through reflation and stabilization". The irony of Fisher's route out of deflation is that, probably only the Fed - after helping lead us into this mess2 - can now get us out of it. Romer's lessons from the Great Depression After reading Fisher's analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture. Lesson 1 – Small fiscal expansion has only small effects Romer wrote a paper in 19923 arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn't large. As Romer notes "When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level... The deficit rose by about one and a half percent of GDP in 1934". Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes "The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936". Romer argues that this "Devaluation followed by rapid monetary expansion broke the deflationary spiral" - empirical evidence to support Fisher's hypothesis outlined above. Lesson 3 – Beware of cutting back on stimulus too soon The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes "The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937". She concludes "taking the wrong turn in 1937 effectively added two years to the Depression". Lesson 4 – Financial recovery and real recovery go hand in hand Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren't really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at "fixing the financial system", witness Bernanke's recent comments "Recovery is not going to happen until the financial markets and the banks are stabilized". This appears to be a misperception, as, Romer notes "Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression". Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn't post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn't make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history - as represented by the balance sheet - cannot simply be ignored when it is inconvenient. As John Hussman noted "The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term "operating profit." Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet." Lesson 5 – Worldwide expansionary policy shares the burdens Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, "Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery... across a wide range of countries in the 1930s... These actions worked to lower world [real] interest rates... rather than just to shift expansion from one country to another". This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view. Lesson 6 – The Great Depression did eventually end The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it "Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American's fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries... would probably have been fully recovered before the outbreak of World War II" This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised. Bernanke and the policy options The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, "Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century." Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based4 one as follows "Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero." In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%! Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds - as the UK is now doing. This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren't talking about trying to 'fix the system', to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken. Investment implications – Cheap insurance Howard Marks recently suggested that today's investment decisions must focus on "value, survivability and staying power". These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year. The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element. Inflation/deflation insurance I – TIPS The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back - representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation). When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade - this strikes me as an exceptionally low rate. Inflation/deflation insurance II – Gold The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can't really value gold - beyond extraction cost. However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can't be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn't such a bad idea against this cataclysmic outcome. Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) - something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed. Inflation insurance I – Dividend swaps As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won't recover, pretty much forever. This strikes me as excessively pessimistic. In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn't have any counterparty issues. Inflation insurance II – Inflation swaps The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%. However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions. Eurozone break-up insurance: Spanish and Portuguese CDS The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn't clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I'll leave a detailed exposition of this logic to Albert in a future note). To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK - where we have the ability (and have used it) to print our own money. Footnotes: 1 Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read! 2 See Bill Flecksenstein's excellent book, Greenspan's Bubbles or John Taylor's insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards' myriad of rants on Greenspan. 3 Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52 4 As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!). John F. 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