Fwd: Unintended Consequences - John Mauldin's Weekly E-Letter

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Subject: Unintended Consequences - John Mauldin's Weekly E-Letter
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Unintended Consequences By John Mauldin | March 25, 2011
In this issue: Loose Monetary Policies and Emerging Markets Bubbles in Emerging Markets Difficult Choices Snowbird, New York, Portland, and La Jolla
The central banks of the developed world are printing money and are engaged in a very-low-interest-rate regime. What does that mean for emerging markets? It is more than just a dilemma, it is a tri-lemma – they have problems not just coming and going but also sitting still! I am in Zurich tonight after a long day, with a 4:30 AM wake-up call to get back home, but deadlines are deadlines. So, to make this one easier on me as well as hopefully instructive for you, you will get chapter 15 of my new book, Endgame, in which coauthor Jonathan Tepper and I speculate about the future of emerging markets in general and investments in them in particular. We once again are on the New York Times best-seller list this week, by the way (thanks to many of you). The reviews keep coming in. I have never met Anthony Harrington, but he is clearly a keen and astute analyst, since he has called this book a must-read. Seriously, he homes in on one aspect that I think is critical; and that is the issue of trade deficits and fiscal deficits and how they affect each other. You can read his work at http://www.qfinance.com/blogs/anthony-harrington/2011/03/23/mauldins-end-game-teaches-politicians-the-basics-but-are-they-listening-austerity-measures. And this week, if you have not yet bought your copy, let me commend you to my friends at Laissez Faire Books. I have been buying books from them for nearly 30 years. They are the best source for Austrian economics and libertarian books, along with the usual offering of investment books current in the market. They have matched the Amazon price for Endgame; but if you are interested, move around their website and pick up a few other things along with my book. http://www.lfb.org/product_info.php?products_id=1014&PromoCode=L401M301 And now, let's look at emerging markets. Loose Monetary Policies and Emerging Markets So far we have focused on the United States and other mature, developed economies that have far too much debt. With Japan, the United States, the United Kingdom, and Switzerland at close to zero percent interest rates, it seemed like a good idea to stimulate the economy. However, emerging markets that maintain pegged currencies or that shadow the dollar are essentially reduced to importing excessively loose monetary policies. Reserve growth across many emerging countries has been very strong over the last year. Emerging Asian countries account for almost 50 percent of global foreign exchange reserves. Huge Asian reserve growth since early last year is a result of mimicking loose monetary policies in the developed world to keep their currencies competitive. China has accumulated the most reserves of any emerging market country. This is directly related to its currency peg and its need to recycle the dollars it gets from its exports. A result of Asian emerging markets' importing loose monetary policy from developed markets is that domestic inflation rates are rising quickly, as policy rates remain too accommodative. Asian emerging market countries are facing a trilemma: They can fix any two of a pegged exchange rate, free flows of capital, or independence in monetary policy, but not all three. The end result is likely to be higher policy rates and currency appreciation. (See Figure 15.1.) Bubbles in Emerging Markets Many emerging markets will double or triple over the next few years. Emerging markets are extremely small as a percentage of total global market capitalization. When investors diversify away from developed markets, it will be like putting a fire hose through a straw. Liquidity from developed markets will overwhelm emerging markets. Part of this is from investors in the developed world wanting to go where the growth is, but part of it is a result of quantitative easing all over the world, especially in the United States. That is why you see emerging markets like Brazil taxing inbound capital flows in an effort to keep their own economies from developing a bubble. (See Figure 15.2.) There are good reasons why the United States and the United Kingdom are among the highest capitalizations. In part, this is because a higher percentage of companies are publicly traded in the United States and the United Kingdom, whereas in other countries, many more are privately held, family-owned, or indeed government-run. Individually, almost all emerging markets are less than 0.5 percent of total world capitalization, as Figure 15.3 shows. To further emphasize the small size of some emerging equity markets and their potential to grow, in Figure 15.4 we have compared the total market caps of some of these markets alongside the market caps of some well-known blue chip stocks (in millions of $). Consider the following examples: Microsoft has a bigger market cap than all of Indonesia, General Electric and Wells Fargo have market caps almost double that of all of the Philippines, Monsanto and Time Warner have bigger market caps than all of Vietnam and Pakistan, and GAP Inc's market cap is almost double that of Sri Lanka's. In the reflation trade, a few characteristics drive outperformance in emerging markets: • Generous liquidity, that is, rapid monetary expansion • Positive demographics • Declining real interest rates • Underleveraged consumer • Banking sector with low loans-to-GDP ratio The main countries that satisfy these requirements are Turkey, Malaysia, India, Indonesia, and Brazil. Local conditions in some emerging market countries will act as a fire starter to excessive liquidity from abroad. In countries like Indonesia, Brazil, and Turkey, due to solid economies, increasing productivity, and thus falling inflation, they are transitioning to lower interest-rate regimes. This often has the consequence of detracting investors from the falling returns on cash and debt products and pulling them toward higher-yielding equities. Further, large populations and still relatively low levels of GDP per capita give some idea of the scope for expansion in countries like China, India, Indonesia, and Sri Lanka if the prosperity of more developed economies, such as Taiwan and the Czech Republic, is anything to go by. In this scenario, liquidity is likely to remain well above the norm for some time, and China will be little different from the other emerging markets: Small markets + Ample liquidity + Investor risk appetite + Historically low interest rates = Bubblelike conditions Chinese equity, property, and other asset markets will benefit hugely. China differs from many other emerging markets because it has tight capital controls that keep a lid on overseas speculation. If these controls were relaxed, however, and the currency allowed to freely fluctuate, then all bets are off as to the effect on Chinese markets. This would be no different from Japan in the 1980s, when the capital accounts were opened up and the yen was allowed to float. Indeed, many if not all of the bubbles that have occurred since the Dutch Tulip Mania in the seventeenth century have been precipitated by a combination of financial liberalization and innovation. There is always a bull market somewhere. If you go back to the 1970s in terms of loose monetary policies and excessive government debt, does that mean that we'll see a repeat of a decade in the doldrums for U.S. and European stock markets? Possibly, but it should not matter to a global macro investor. Again, there are always bull markets somewhere. Figure 15.5 shows that from 1970 to 1985, if you had invested $1 in the United States, you would have $2 by 1985. If you had invested in Japan, you would have made $6 over the same period, and if you had invested in Hong Kong, you would have made more than $8. Emerging markets will be the big winners of the loose monetary policies around the world. Just as the Fed's loose monetary policy after the Internet bubble burst created the housing bubble, the Fed's money printing will inflate emerging markets. The surplus liquidity isn't likely to ignite an inflationary boom in the U.S. economy if consumers refuse to borrow and spend. But that liquidity has to go somewhere, and emerging markets look like the most likely destination. Emerging markets and commodities took the first hits in the credit implosion because they were viewed as warrants (longterm call options) on global growth. As history shows, the leading sector of the previous bull market typically is not the leader of a new bull market. The emerging markets look like they are the new global leaders. Emerging economies account for 43.7 percent of global output and, according to the IMF, will account for 70 percent of the world's growth going forward, yet they represent only 10.9 percent of global stock market capitalization. China by itself makes up 15 percent of the global economy but less than 2 percent of market cap, while the United States provides 21 percent of output but 43.4 percent of market cap. Most investors weight the American and European markets too heavily. This is partly due to home bias in investing, but it is really more like a drunk searching for his keys under the lamppost. He searches there not because he is likely to find his keys but because there is light. In the same way, most investors in emerging markets do not look for the right data and merely decide to either take risk and invest or reduce risk and withdraw funds. Their investments into emerging markets are unsystematic. Most investors buy or sell emerging markets indiscriminately based on their willingness to take on further risk or shed risk. Figure 15.6 shows the extremely high correlation between the VIX Index, global equity volatility, and the U.S. dollar versus South African rand exchange rate (USDZAR). You can't make up charts like this. During the emerging markets rally in 2006 and 2007, almost all markets traded in line with the others. Figure 15.7 shows that for much of 2006, the Indian Sensex and the Mexican Bolsa Index had a 96 percent correlation, even though their economies could not have been more different. (File under the "investors are lemmings" category.) Emerging markets could easily be the next bubble. However, they don't even need to be the next bubble or the next big thing for investors to profit from them. As recessions ended in the United States and Europe in 1992 and 2003 and central banks kept liquidity flowing freely, almost all emerging markets rallied indiscriminately. Loose liquidity and undervalued emerging market currencies are leading toward excess foreign exchange reserve accumulation and loose credit conditions. Underleveraged emerging markets with higher velocity will continue to benefit from the accommodative monetary policies of a developed world beset with high debt and low monetary velocity. Continued reserve accumulation can lead to inflationary pressure, overinvestment, complications in the management of monetary policy, misallocation of domestic banks' lending, and asset bubbles. Difficult Choices We have written about the difficult choices developed countries will face as they deal with the hangover from too much debt. Emerging market countries face the flip side of the same problem. They are, for the most part, underleveraged and have higher monetary velocity, yet they are importing the loose money policies from the United States and Europe. What can emerging markets do to try to reduce inflows of hot money and prevent bubbles? There are a number of tools available to policy makers of liquidity-receiving economies in response to excess global liquidity and large capital inflows. As the IMF has pointed out, emerging markets can allow a more flexible exchange rate policy. They can accumulate reserves (using sterilized or unsterilized intervention as appropriate). They can reduce interest rates if the inflation outlook permits, and they can tighten fiscal policy when the overall macroeconomic policy stance is too loose. All of these involve difficult tradeoffs where the costs and benefits are not obvious. The bottom line is that governments around the world need to be alert and make difficult choices to deal with a world excess liquidity. From an investor's point of view, we would enjoy the current ride in emerging markets but recognize that they are high beta to the U.S. economy and stock markets. The next time the United States goes into recession—and there will be a next time—it is likely that emerging markets will suffer significant losses. So, emerging markets are a trade and not a long-term investment. That being said, at the bottom of the next U.S. recession, we think emerging market countries could see their economies and stock markets finally decouple from the United States, and at that point, they could become the trade of the decade. We suggest that investors use the time to find specific stocks and not just country ETFs, or find someone who can do that work for you. Fortunes can be made if you do your homework. Snowbird, New York, Portland, and La Jolla Let me remind you that my conference in La Jolla is filling up and the registration deadline is looming. As I said last week, at my Strategic Investment Conference, the first two questions that each speaker will get at the end of their presentation will be, first, "What will happen when QE2 goes away?" and second, "Under what conditions will the Fed launch QE3?" I will pose them to Martin Barnes, Marc Faber, Louis-Vincent Gave, Paul McCulley, David Rosenberg, and Gary Shilling – and John Paulson has agreed to speak as well! They will be joined by Neil Howe (The Fourth Turning, and demographics guru) and George Friedman of Stratfor, as well as your humble analyst and Altegris partner Jon Sundt. I mean, really, is there a conference anywhere this year that has a line-up that powerful? The conference is April 28-30 in La Jolla. It is filling up fast. You can register at https://hedge-fund-conference.com/2011/invitation.aspx?ref=mauldin. Sadly, it is for accredited investors only, but I will report back to you the answers from the speakers to those questions. As noted at the outset, I am in Zurich tonight. The weather in Europe this week has been fantastic, some of the best I have ever had. London, Malta, Milan, Zug, Zurich – just brilliant. I had dinner outside with Massimo Lattman on Lake Zurich tonight. A very successful entrepreneur and manager, he had such great stories and insights to share, on a gorgeous night. You live for moments like that. Saturday I am off to Snowbird, Utah, for my partner at SMG Steve Blumenthal's 50th birthday party, then on to New York on Sunday for meetings and media to help promote the book. I will detail the schedule next week. I will also be providing the keynote address for the West Coast-based investment advisory firm of Arnerich Massena at their 2011 Investment Symposium, on April 11-12, in Newberg, Oregon, outside of Portland. OK, don't tell my kids about this next bit. (When we travel together, I am a bit of a stickler about schedules. Moving seven kids and their families with kids can get to be a logistical issue. Dad can get on their case if they don't move fast enough. So, last night I was with Niels Jensen on the train from Milan to Zug, our destination a quaint little "village" in Switzerland near Zurich. Lots of fund managers are moving there for tax reasons, lifestyle, etc. It was late and I was writing away on the train, deep in my creative throes, charmed with an idea for a new research report I am writing. Niels said, "John, you might want to pack up. We are getting close." I looked at my watch and thought I had five minutes, so I kept typing away. Creative juices and all, you know? You've got to give the Muse her lead. However, we pulled into the station sooner than I expected. I started packing up quickly, but there were a lot of wires and stuff. Spilled the last of the Prosecco on my coat (is that maybe why I thought I was creative?). I ran to the door, only to have it close and lock, and watched Niels, standing with my luggage on the platform, waving goodbye as the train pulled out! Nothing to do but feel like an idiot and travel on to Zurich, then take the next train back (this one with local stops) to Zug. I got to the small hotel. No one was at the desk or would answer the phone. Not knowing what to do, I looked around and saw there was a key on the counter. Next to it was a note reading, "Mr. Mauldin, your luggage is in your room. Have a good night." Anywhere else this is an invitation to free luggage. In Zug, I guess, this is how they take care of latecomers. The next day, as we are back at the train station, heading for Zurich, this gentleman walks up and asks, "Are you John Mauldin? I have this new econometric model I've been wanting to show you." So, on the train to Zurich I looked at feedback mechanisms and how they can be used to analyze markets. Actually quite intriguing. It is a small damn world, but a really fun one. It is time to hit the send button. The wake-up call will come way too soon. But, there is a party going on underneath my hotel room window. They are singing songs from the '60s and '70s here in the Old Town in Zurich. Maybe just one drink and then bed. Have a great week! Auf wiedersehen! Your loving Switzerland analyst, John Mauldin John@FrontlineThoughts.com Copyright 2011 John Mauldin. All Rights Reserved
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Thoughts From the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.JohnMauldin.com. Please write to johnmauldin@2000wave.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.JohnMauldin.com. To subscribe to John Mauldin's E-Letter please click here: http://www.frontlinethoughts.com/subscribe To change your email address please click here: http://www.frontlinethoughts.com/change-address 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. 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Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe Or send an email to: wave@frontlinethoughts.com This email was sent to jmiller2000@gmail.com You subscribed at www.johnmauldin.com Thoughts from the Frontline | 3204 Beverly Drive | Dallas, Texas 75205

Fwd: The Seven Immutable Laws of Investing - John Mauldin's Outside the Box E-Letter

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From: John Mauldin and InvestorsInsight <wave@frontlinethoughts.com>
Date: Mon, Mar 21, 2011 at 8:13 PM
Subject: The Seven Immutable Laws of Investing - John Mauldin's Outside the Box E-Letter
To: jmiller2000@gmail.com

	Contact John Mauldin Print Version Download PDF Volume 7 - Issue 12 March 21, 2011 The Seven Immutable Laws of Investing By James Montier I am in London this morning, just a few miles (in theory) from the writer of this week's Outside the Box. James Montier, now with GMO, is one of my favorite analysts. I read everything he writes, and my only complaint is that he does not write enough. Today he offers us his thoughts on what he calls the "7 Immutable Laws of Investing." Co-hosting Squawk Box for two hours this morning with Geoff and Steve was fun. They took the time to have some thoughtful conversations on a wide variety of topics, as well as have some fun. Malta, Milan, and Zug/Zurich, and then back home. Book launch party in a few hours, so let's just jump into James's work. Your wondering what time it is analyst, John Mauldin, Editor Outside the Box The Seven Immutable Laws of Investing James Montier In my previous missive I concluded that investors should stay true to the principles that have always guided (and should always guide) sensible investment, but I left readers hanging as to what I believe those principles might actually be. So, now, for the moment of truth, I present a set of principles that together form what I call The Seven Immutable Laws of Investing. They are as follows: Always insist on a margin of safety This time is never different Be patient and wait for the fat pitch Be contrarian Risk is the permanent loss of capital, never a number Be leery of leverage Never invest in something you don't understand So let's briefly examine each of them, and highlight any areas where investors' current behavior violates one (or more) of the laws. 1. Always Insist on a Margin of Safety Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate Law 1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. I've been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000. For the article, they used this lead: "Admit it, you still have nightmares about the ones that got away. The Microsofts, the Ciscos, the Intels. They're the top holdings in your ultimate 'coulda, woulda, shoulda' portfolio. Oh, what might have been, you tell yourself, had you ignored all the naysayers back in 1990 and plopped a modest $5,000 into, say, both Dell and EMC and then closed your eyes for the next ten years. That's $8.4 million you didn't make. "Now, hold on a minute. This is no time for mea culpas. Okay, so you didn't buy the fastest growers of the past decade. Get over it. This is a new era – a new millennium, in fact – and the time for licking old wounds has passed. Indeed, the importance of stocks like Dell and EMC is no longer their potential as investments (which, though still lofty, is unlikely to compare with the previous decade's run). It's in their ability to teach us some valuable lessons about investing from here on out." Rather than sticking with these "has been" stocks, Fortune put together a list of ten stocks that they described as "Ten Stocks to Last the Decade" – a buy and forget portfolio. Well, had you bought the portfolio, you almost certainly would wish that you could forget about it. The ten stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley, and Genentech. The average P/E at purchase for this basket was well into triple figures. If you had invested $100 in an equally weighted portfolio of these stocks, 10 years later you would have had just $30 left! That, dear reader, is the permanent impairment of capital, which can result when you invest with no margin of safety. Exhibit 1: Fortune Magazine's Ten Stocks to Last the Decade The securities identified above represent a selection of securities identified by GMO and are for informational purposes only. These specific securities are selected for presentation by GMO based on their underlying characteristics and are not selected solely on the basis of their investment performance. These securities are not necessarily representative of the securities purchased, sold or recommended for advisory clients, and it should not be assumed that the investment in the securities identified will be profitable. Source: Bloomberg, Datastream, GMO As of 6/30/10 Today it appears that no asset class offers a margin of safety. Cast your eyes over GMO's current 7-Year Asset Class Forecast (Exhibit 2). On our data, nothing is even at fair value, so from an absolute perspective all asset classes are expensive! U.S. large cap equities are offering you a close to zero real return for the pleasure of parking your money in them. Small cap valuations indicate an even worse return. Even emerging market and high quality stocks don't look cheap on an absolute basis; they are simply the best relative places to hide. These projections are reinforced for equities when we investigate the number of stocks able to pass a deep value screen designed by Ben Graham. In order to pass this screen, stocks are required to have an earnings yield of twice the AAA bond yield, a dividend yield of at least two-thirds of the AAA bond yield, and total debt less then two-thirds of the tangible book value. I've added one extra criterion, which is that the stocks passing must have a Graham and Dodd P/E of less than 16.5x. As a cursory glance at Exhibit 3 reveals, there are very few deep value opportunities in global markets currently. Bonds or cash often offer reasonable opportunities when equities look expensive but, thanks to the Fed's policy of manipulated asset prices, these look expensive too. Exhibit 2: GMO 7-Year Asset Class Return Forecasts* as of January 31, 2011 * The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. 1 Long-term inflation assumption: 2.5% per year. Source: GMO Exhibit 3: % of Stocks Passing Graham's Deep Value Screen * With additional criterion that stocks have a Graham and Dodd P/E of less than 16.5x. Source: GMO As of 3/29/10 In order to assess the margin of safety on bonds, we need a valuation framework. I've always thought that, in essence, bond valuation is a rather simple process (at least at one level). I generally view bonds as having three components: the real yield, expected inflation, and an inflation risk premium. The real yield can either be measured in the market via inflation-linked bonds, or an estimate of equilibrium (or normal) real yield can be used. The TIPS market currently offers a real yield of 1% for 10-year paper. Rather than use this, I've chosen to impose a "normal" real yield of around 1.5%. To gauge expected inflation we can use surveys. For instance, the First Quarter 2011 Survey of Professional Forecasters2 shows an expected inflation rate of just below 2.5% annually over the next decade. Other surveys show little variation. The use of surveys of forecasts might seem a little at odds with my previously expressed disdain for forecasts. But because history has taught me that the economists will be wrong on their inflation estimates, I insist on including the final element of the bond valuation: the inflation (or term) risk premium. Estimates of this risk premium range, but I suggest it should be between 50-100 bps. Given the uncertainty surrounding the use and impact of quantitative easing, I would further suggest a figure closer to the upper range of that band currently. Adding these inputs together gives a "fair value" of somewhere between 4.5-5%. The current 3.5% yield on U.S. 10- year bonds falls a long way short of offering investors even a minimal margin of safety. Of course, the bond bulls and economic pessimists will retort that the market is just waking up to the impending reality that the U.S. is set to follow Japan's experience and spend a decade or two mired in a deflationary swamp. They may be correct, but we can assess the probability that the market is placing on this scenario. In constructing a simple scenario valuation, let's assume three possible states of the world (a gross simplification, but convenient). In the "normal" state of the world, bond yields sit close to their fair value at, say, 5%. Under a "Japanese" outcome, the yield would drop to 1%, and in a situation where the Fed loses control and inflation returns, yields rise to 7.5% (roughly speaking, a 5% inflation rate). If we adopt an agnostic approach and say that we know nothing, then we could assign a 50% probability to the normal outcome, and 25% to each of the tails. This scenario would generate an expected yield of very close to 4.5%. We can tinker around with the probabilities in order to generate something close to the market's current pricing. In essence, this reveals that the market is implying a 50% probability that the U.S. turns into Japan. This seems an extremely lopsided implied probability. There are certainly similarities between the U.S. and Japan (e.g., zombie banks), but there are marked differences as well (e.g., the speed and scale of policy response, demographics). A 50% probability seems excessively confident to me. Exhibit 4: Bond Scenario Valuation Source: GMO Our concerns about the overvaluation of bonds have implications for both our portfolios and for relative valuation. Obviously, you won't find much fixed income exposure in our current asset allocation portfolios given the valuation case laid out above. One of the "arguments" for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I've described this as the ugly stepsisters' problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I'd rather wait for Cinderella to come along. Of course, the argument to buy stocks because bonds are appalling is really just a version of the so-called Fed Model. This approach is flawed at just about every turn. It fails at the level of theoretical soundness as it compares real assets with nominal assets. It fails empirically as it simply doesn't work when attempting to predict long-run returns (never an appealing trait in a model). Moreover, proponents of the Fed Model often fail to remember that a relative valuation approach is a spread position. That is to say that if the Model says equities are cheap relative to bonds, it doesn't imply that one should buy equities outright, but rather that one should short bonds and go long equities. So the Model could well be saying that bonds are expensive rather than that equities are cheap! The Fed Model doesn't work and should remain on the ash heap. Exhibit 5: What Relationship Between Bonds and Equities? Source: GMO As of 1/12/11 Relative valuation holds little appeal to me and even less so when I consider that neither bonds nor equities are even vaguely stable assets. In general, when valuing an asset you want a stable anchor by which to assess the scale of the investment opportunities. For instance, one of the reasons that the Graham and Dodd P/E (current price over 10-year average earnings) works well as a valuation indicator is the slow, stable growth of 10-year earnings. In contrast, the bond market was happy to extrapolate the briefest peak of inflation to over 30 years in the early 1980s, and similarly was willing to extrapolate the deflationary risks of 2009 for over 10 years. Using such an unstable asset as the basis of any valuation seems foolhardy. I'd rather consider the absolute merits of each investment independently. Unfortunately, as noted above, this currently reveals an unpleasant truth: nothing offers a good margin of safety. In fact, if we look at the slope of the risk return line (i.e., the 7-year forecasts measured against their volatility), we can see that investors are being paid a paltry return for taking on risk. Admittedly, Mr. Market is not yet as manic as he was in 2007 when we faced an inverted risk return trade-off – investors were willing to pay for the pleasure of holding risk – but at this rate, I believe it won't be long before we are once again facing such a perverse situation. Albeit this time it is officially-sponsored madness! Exhibit 6: The Slope of the Risk Return Line Source: GMO As of February 2011 This dearth of assets offering a margin of safety raises a conundrum for the asset allocation professional: what does one do in a world where nothing is cheap? Personally, I'd seek to raise cash. This is obvious not for its thoroughly uninspiring near-zero yield, but because it acts as dry powder – a store of value to deploy when the opportunity set offered by Mr. Market once again becomes more appealing. And this is likely, as long as the emotional pendulum of investors oscillates between the depths of despair and irrational exuberance as it always has done. Of course, the timing of these swings remains as nebulous as ever. 2. This Time Is Never Different Sir John Templeton defined "this time is different" as the four most dangerous words in investment. Whenever you hear talk of a new era, you should behave as Circe instructed Ulysses to when he and his crew approached the Sirens: have a friend tie you to a mast. Because I have discussed the latest notion of a new era in my recent "In Defense of the 'Old Always,'" I won't dwell on it here. I will point out, though, that when assessing the "this time is different" story, it is important to take the widest perspective possible. For instance, if one had looked at the last 30 years, one would have concluded that house prices had never fallen in the U.S. However, a wider perspective, drawing on both the long-run data for the U.S. and the experience of other markets where house prices had soared relative to income, would have revealed that the U.S. wasn't any different from the rest of the world, and that a house price fall was a serious risk. 3. Be Patient and Wait for the Fat Pitch Patience is integral to any value-based approach on many levels. As Ben Graham wrote, "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants." (And there can be little doubt that Mr. Market's love affair with equities is based on anything other than artificial stimulants!) However, patience is in rare supply. As Keynes noted long ago, "Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuations of what they hold, and on capital appreciation… and too little on immediate yield … and intrinsic worth." If we replace Keynes's "quarterly" and "monthly" with "daily" and "minute-by-minute," then we have today's world. Patience is also required when investors are faced with an unappealing opportunity set. Many investors seem to suffer from an "action bias" – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch. 4. Be Contrarian Keynes also said that "The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive." Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive. Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis. Currently, there is an overwhelming consensus in favor of equities and against cash (see Exhibit 7). Perhaps this is just a "rational" response to Fed policies that actively encourage gross speculation. William McChesney Martin, Jr. observed long ago that it is usually the central bank's role to "take away the punch bowl just when the party starts getting interesting." The actions of today's Fed are surely more akin to spiking the punch and encouraging investors to view the markets through beer goggles. I can't believe that valuation-indifferent speculation will end in anything but tears and a massive hangover for those who insist on returning again and again to the punch bowl. 5. Risk Is the Permanent Loss of Capital, Never a Number I have written on this subject many times.4 In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn't a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure. To my mind, the permanent impairment of capital can arise from three sources: 1) valuation risk – you pay too much for an asset; 2) fundamental risk – there are underlying problems with the asset that you are buying (aka value traps); and 3) financing risk – leverage. By concentrating on these aspects of risk, I suspect that investors would be considerably better served in avoiding the permanent impairment of their capital. 6. Be Leery of Leverage Leverage is a dangerous beast. It can't ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn't transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital. Exhibit 7: BoAML Fund Manager Survey (Equities and Cash) While on the subject of leverage, I should note the way in which so-called financial innovation is more often than not just thinly veiled leverage. As J.K. Galbraith put it, "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." Anyone with familiarity of the junk bond debacle of the late 80s/early 90s couldn't have helped but see the striking parallels with the mortgage alchemy of recent years! Whenever you see a financial product or strategy with its foundations in leverage, your first reaction should be skepticism, not delight. 7. Never Invest in Something You Don't Understand This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can't see through the investment concept and get to the heart of the process, then you probably shouldn't be investing in it. Conclusion I hope these seven immutable laws help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital. Right now, I believe the laws argue for caution: the absence of attractively priced assets with good margins of safety should lead investors to raise cash. However, currently it appears as if investors are following Chuck Prince's game plan that "as long as the music is playing, you've got to get up and dance." John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. Please write to Reproductions@InvestorsInsight.com and inform us of any reproductions including where and when the copy will be reproduced. 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