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Grantham fall letter [ClearOnMoney]
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Commentary

Grantham fall letter

27 Oct 2010 by Jim Fickett.

Jeremy Grantham's fall letter is mainly a critique of the Fed. It also reiterates investment thoughts pretty similar to past letters, with resource stocks gaining in prominence.

Jeremy Grantham's fall letter (registration required) came out Monday. 12 out of 16 pages are devoted to criticism of Federal Reserve policy, which Grantham regards as both destructive and dangerous. He states the purpose of this part of the letter so:

Only by hammering away at [the Fed's] giant past mistakes as well as its dangerous current policy can we hope to generate enough awareness by 2014: Bernanke’s next scheduled reappointment hearing.

I would add that since the Fed is one of the most potent and capricious forces in the market, it behooves every investor to understand the Fed's manipulations as well as possible.

Most arguments in favor of Fed monetary policy come in one of three flavors: (1) since many people are suffering, something must be done, (2) terrible things happened in the Great Depression, or Japan's lost decades, etc., and these could have been prevented by better policy, and (3) certain equations say that a certain monetary policy ought to work. Of course the first argument only supports action as against inaction, but is not an argument for any particular policy. The second argument is quite weak – it is always unclear how strong any parallels between any particular historical event and the present may be, as well as what might have been the outcome with a different policy in the past. The third argument may well be the strongest, but I find that most economists defending policy take the equations as given, and I need to be convinced that they are relevant, especially since so often the arguments of economists about the markets turn out to be wrong. So I rarely find arguments in support of Fed policy compelling.

On the other hand, it must be said, many arguments against Fed policy are just as weak, often consisting mainly of sarcastic remarks, or vague comments about the lack of value in paper money. So it is a nice change of pace that Grantham brings in some interesting empirical data to support his thesis that Fed policy is mostly short term manipulation of markets that does not really contribute to long term economic health or growth.

So here are a few of Grantham's points, and how they are supported by historical trends.

1. Fed policy usually encourages the growth of debt, but higher debt is associated with lower GDP growth. As national debt has grown from about 130% of GDP in 1952 to 350% of GDP recently, trend growth in GDP has fallen from 3.4%/year to 2.4%/year. The increase in debt has the negative effect of causing the financial sector to grow.

2. The presidential cycle shows how Fed intervention transmits to the markets and the economy. (It also shows, I would add, that Fed independence is somewhat overstated.) In year 3 of the presidential cycle, the Fed funds rate drops by 0.6% on average, the real value of stocks goes up by an average of 17.6%, and the net effect on the real economy is mildly negative (-0.3% change in GDP growth and +0.15% change in unemployment). In the fourth year of the presidential cycle, when the effect on the economy is politically needed, the average change in the Federal Funds rate is +0.3%, the real value of stocks goes up by only 1.7%, but the economy now sees a boost: unemployment drops by 0.3% and GDP growth increases by 0.6%. By looking at correlation between gains in the stock market and GDP growth the following year, independently of Fed policy, Grantham concludes that what the Fed mostly does is manipulate asset prices upward, which, via the wealth effect, causes more spending and hence a short-term boost to the economy.

3. Fed policy moves more volatile stocks more than the S&P 500 as a whole, and moves world markets, not just the US. On the latter point, UK stock returns in US presidential years 3 are 24% better than average.

4. Many have argued that artificially low rates (and government bailouts) cause weaker companies to survive when perhaps they should be allowed to fail. In support of this idea, Grantham shows that smaller companies (presumably also financially less stable than larger ones) perform better than the rest of the market during periods of negative real interest rates.

If you find policy questions interesting, Grantham's critique of the Fed is among the most useful I've seen, and well worth reading in its entirety.

Back to investing.

Current Investing Questions

1) Does this year being a Year 3 of the Presidential Cycle confuse the issue?

Yes. … the record says that 19 Year 3s have occurred since FDR with not one serious bear market … Who wants to bet on the 20th being different this time? Yet, if ever there were an argument for “this time is different,” this is it, isn’t it? This year, a Year 3 has been preceded by two abnormally stimulated years when, typically, the Fed works to cool the markets down in Years 1 and 2. … we may get lucky and have a chance to buy cheaper stocks. But probably not yet. …

2) Should we hold onto quality stocks?

For sensible long-term investors, the probable outcome of a further speculative rally as described above would be irritating and resolve testing. … [But quality stocks] are getting so cheap relative to the market that a wider range of buyers is finally noticing them. … there is a decent chance, say one in three, that quality stocks are so cheap that they will “unexpectedly” hang in. …

3) How far can emerging equities go? …

Everyone and his dog are now overweight emerging equities, and most stated intentions are to go higher and higher. Emerging markets are admittedly fully priced, but they still sell at a decent discount to the 75% of the S&P 500 that are not quality stocks – a particularly strange quirk in a strange market. …

4) What to do about raw materials? …

I really believe that we are in a new world in which we are running out of resources … a world that only China truly gets. (For the record, I singled out rare earths in my 2Q 2009 Letter.) … My personal advice (i.e., how I invest my sister’s pension fund, etc.) is to give the benefit of any doubts for very long-horizon (20 years) investments to resources in the ground, agricultural land, and, above all, forestry. Resource stocks, though, have really run, and a serious price decline caused by, say, China’s stumbling, would of course make for a much better entry point …

5) Should we buy overpriced stocks when bonds are even worse? …

We use the long-term returns for stocks to decide what their fair value is. They are currently overpriced. Bonds are even less attractive. Yet, remember that in a strongly mean-reverting world, you need to be careful about enthusiastically buying the less ugly of two overpriced investments. Cash has an option value: on the chance that stocks or bonds or, better yet, both, decline, the investor will need resources from which to buy. …

6) Religious wars (or, Should we buy gold?)

Everyone asks about gold. This is the irony: just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. … In the longer run, I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any inflation or paper currency crisis than is gold.