Friday, May 30, 2014

Profiting from Depreciation

Summary:
   The global supply of base money is growing at a ferocious pace.  The US is tapering (still expanding the money supply, but at a slowing pace), and the velocity of money is likely to pick up causing broad money measures to continue expanding.   More dramatically, the rest of the world has joined in our money printing efforts, with the central banks of UK, ECB, Japan, and Switzerland aggressively increasing the size of their balance sheets.  Productivity is growing far slower than the money creation, so we're seeing currency depreciation that is likely to accelerate.  If all the major currencies depreciate simultaneously, exchange rates won't necessarily move.  Rather the prices of real assets (like commodities and real estate) generally increase. Slack in the labor market is shrinking, so the price increases in real assets may spread more generally and produce moderate inflation. 
    The big challenge is that the money printing has already pushed up the price of assets that provide yield to very "optimistic" levels.  The cap rates on real estate (basically a measure of yield) are low, reflecting both the low interest rate environment and the minimal risk premium.  The pricing for companies that provide commodities is similar.  This makes it difficult to get excited about buying a lot of the traditional depreciation/inflation hedges.  Investing is 1/3 about making the right prediction, but 2/3 buying at the right price. 
   My best guess is that moderate inflation is about 18 months away, but the market will begin positioning for it sooner.  I suggest purchasing a basket of assets that do well under stagflation regimes (low growth, moderate inflation), as well as under pure currency depreciation scenarios.  This includes a focus on precious metals, with smaller allocations to REITs with pricing power (like hotels), the equity of companies that benefit directly from rising commodity prices (miners, farmers, drillers, wildcatters, energy servicing companies etc), pure commodities, and maybe a little Bitcoin.  Insofar as you hold equities, it's smart to focus on emerging market economies; EM equities are trading much cheaper than the US and those countries will likely benefit disproportionately from continued money printing.  Probably the clearest advice is what not to own.  Fixed income of all types will do poorly.  

The Growing Money Supply:
The central banks of the world are in full out money printing mode.  The US led the way beginning in 2008 and ultimately produced a staggering 5x increase in the base money supply, but Europe and Japan have been ramping up their own efforts.  While the US federal reserve is "tapering", this simply means they're printing money at a slower rate than before, but they're still printing, and as I'll discuss shortly, the US money supply is likely to continue growing quickly.  Central banks are printing money faster than productivity is growing, which means the value of currencies will depreciate in real terms.  We usually think of the value of a currency as an exchange rate, but what if all currencies are depreciating together?  You get price increases in real assets.  Whether that turns into general inflation depends on whether labor can demand wage increases, and that depends on the amount of slack in the labor market.  Economists are debating that last point at length, but the debate centers around a pretty narrow range.  Is "hidden" unemployment an extra 1% or 3%?  The slack in question is really minimal compared to the upward pressure on demand from the flood of cash, and global GDP growth will continue eroding whatever slack remains in the coming year.  
   Distinguishing between inflation and global currency depreciation is tricky.  The former is a self-sustaining cycle that must eventually include wage increases and rising consumer demand.  If there's enough slack in the labor market, it's possible to get global currency depreciation without inflation.  In an inflationary scenario, "useful" assets like housing and crude oil are more likely outperform.  In the depreciation without inflation scenario, currency alternatives like gold will likely outperform.  Whether depreciation will turn into inflation requires a complicated and contentious discussion of the amount of slack in the global economy. 

Monetary Basics:
Back in 2008, market watchers noted that the Fed Balance sheet had ballooned from $800 billion to $2,200 billion dollars, and it has continued rising to over $4,000 billion.  Economics 101 tells us that Price x Quantity = Money Supply x Velocity of Money.  The equation tells us that if the money supply increases and neither velocity nor productivity changes, then prices must rise.  In even simpler terms, if there's more money chasing the same goods, prices will rise.  
  So why didn't prices increase threefold in 2008?  The velocity of money collapsed.  People hoarded their cash and used earnings to pay down debt instead of invest or consume.  Similarly, banks hoarded their capital instead of making loans.  None of this was surprising in 2008, or 2009, or even 2010.  But now in 2014 with the economy humming along with moderate growth, it's surprising that the velocity of money remains at recession levels.  There's a lot of debate on exactly why this is, mostly centered around a reduction in the size of the "shadow banking" system.  The bigger question is when will velocity normalize and what "normal" means.  I don't have good answers for you here, except that the rise in asset prices, expected low real yields, decreasing labor slack, and increasing money printing out of the weaker parts of the global financial system (ECB and Japan), will likely push up the money multipliers sooner rather than later.  

Bonds Moving With Stocks:
People often think of bonds and stocks as moving in opposite directions, but this has only been true for about 1/3 of the time over the last 50 years.  When we're in a deflationary environment (or a high real growth environment), the correlation is negative, as it has been for the last 12 years.  But when inflation is the focus, the correlation is positive, as it was from 1970 to 2000.  The last 5 years have had the most negative bond/stock correlations of all time, and I think that will soon reverse.  Here is a chart of the stock/bond correlation using 5-year rolling returns.  Being short bonds is currently a crowded trade, but the fundamentals are correct.  Interest rates are near all time lows and at the end of a generational cycle.  


What To Buy
  I've written in the past that gold is a mediocre inflation hedge.  The best predictor of gold returns is not inflation, but real returns.  When other assets offer opportunity, investors prefer them.  When other assets look ugly, investors are content keep their wealth in gold.  Quantitative easing has pushed every asset class to at least fair value if not far above fair, and with interest rates suppressed globally, real returns are likely to be very low over the next decade.  This makes gold an attractive inflation hedge in the current economic regime. I haven't kept a close eye on the commodity markets over the past year, so I'm wary of offering specific recommendations.  Personally I've bought a basket with an emphasis on natural gas, for similar reasons to what I wrote two years ago.  For investments of longer than a year, I generally prefer investing in companies that profit from commodities rather than in commodities themselves.  Equity investment provides a "tailwind"; even if commodities remain at current prices, the companies can earn a reasonable return and their equity may still appreciate at 5%+ a year.  Second, while you can buy physical gold and store it, it's not feasible to do this for things like crude oil or corn.  Owning commodity futures for more than a year incurs roll costs and unfavorable tax treatment, and ETFs are forced to roll their holdings and get taken advantage of by traders.  With all that said, I think that US equity markets are generally overpriced, so I'm also including some pure commodities in my basket.  
   A speculative candidate for addition to your portfolio is bitcoin.  Bitcoin is a cryptographic method of transferring value.  There's debate as to whether it's best thought of as a currency, commodity, or simply a method of transaction like Visa.  Regardless, it supports a fascinating variety of new technologies that may become integrated into the real economy in all sorts of interesting ways.  The biggest names in Venture Capital like Andreessen Horowitz as well as major players like Richard Branson and Li-Kashing are pouring money into bitcoin related start-ups.  It's inherently deflationary by nature as well, so investors may like allocating some portion of their wealth to it as a hedge against currency depreciation and inflation.  To be clear, bitcoin is not an investment, it's speculation.  It could easily collapse to worthlessness in the near future.  But...I think it's a smart addition as a small part of your portfolio, and I think it has the potential to achieve 5x returns in the near future.
   

Your Thoughts?
  I generally lack the time these days to delve into specific assets in great detail.  Do you like a particular commodity, company, or equity index as a depreciation/inflation hedge?  I'd love to hear from you.

Yen
  The trade I've recommended most strongly in the last 3 years was shorting the Yen, and that's worked out very nicely.  The easiest money is already captured so I've cut my position to 25% of the original size.  The long-term fundamentals continue to support shorting the Yen and I expect to leave on the remaining position for another 5 years or so.  The basic reasoning that I put forward back in January of 2012 remains sound.

Cheers,
Ari

Tuesday, January 21, 2014

The view from 10,000 ft.

Investors,

   While short-term forecasts are near impossible, and medium-term is hard and requires a lot of luck, long-term forecasting is easier because market values generally head towards "fair" and mean reversion operates at a lot of levels.  The best long-term forecaster that I'm aware of is Jeremy Grantham, partner at GMO.  Grantham produces 7 and 10-year forecasts based on fundamental relationships and the assumption that over a long time frame, asset classes will revert to intrinsic value.  His current forecast suggests that US equity real returns over the next 7-years will be negative; he thinks US equities are currently 75% overvalued.
   He updates the forecasts quarterly to account for changes in things like GDP and investment levels, but most importantly, to account for changes in asset prices.  In 1999 he predicted that equity returns over the next 10 years would be zero, a staggering contrarian prediction at the time.  After the tech bubble burst, he became moderately bullish in 2002 before again predicting negative long-term equity returns in 2007.  He was then bullish again in 2009 before becoming bearish in 2012.  He also correctly forecast the outperformance of commodities and emerging market equity in the 2000s.  This is not to suggest that his timing is perfect; he became skeptical of equities in 1997, 3 years too early.  He seems to have little skill in picking the turning point, but is excellent in identifying when we're far above or below the "trend line" to which we will eventually revert.  
   The bulk of his work is to simply ignore the narratives of the pundits, and focus on some very basic metrics that ultimately drive returns.  For equities, long-term returns come down to revenue and profit margins (which determine net profits), leverage (which converts profits to return to equity), and the earnings multiple (which converts earnings per share to a stock price.)  Revenue generally trends upwards with the economy, and the rest is strongly mean reverting.  While we can't know what the mean reverting level is exactly, we can be sure that, for example, profit margins won't climb and climb until breaking 100%, and the P/E ratio must ultimately relate to real interest rates.  
   This simple analysis is just the starting point however, because things do fundamentally change over time.  For example, the top quartile of venture capital funds earned annualized returns of over 40% from 1990 to 2000.  That's likely a decade that will never be repeated for venture capital, because it was a new, underpopulated asset class investing in a new, underinvested industry.  Today venture capital is crowded with ten times the capital chasing a similar number of opportunities. 
  Long-term secular environments are also critical.  We're now 5 years into a period of financial repression with artificially low real interest rates.  The further the government pushes real interest rates below equilibrium, the higher asset prices may get above fair value.  
   Grantham thinks the biggest cause of excess market volatility and mispricing is faulty extrapolation.  Investors assume that trends will continue indefinitely, instead of identifying short-term aberrations for what they are.  For example, investors consistently overprice "growth" stocks, despite research showing that future earnings of growth and value stocks are actually the same; in other words, the prior revenue growth rate has no predictive value for future revenue growth rates.  This is why mindlessly buying stocks with low price to earnings ratios has outperformed most professional investors over the last 90 years.  Right now, the biggest false extrapolation is profit margins.  It depends on the measure you use, but profit margins are about 35% too high.  This means that if absolutely nothing else changes with the economy or corporate fundamentals and valuations, we should expect net profits to fall 35% and stock prices to fall 35%.  Of course the adjustment is unlikely to happen instantly, so the market may adjust to lower profit margins over time while other inputs into stock valuation provide support (e.g. stocks may lose 35% from lower margins but gain an offsetting 35% from revenue growth over the next 4 years).  
    Here is a link to an article about GMO's methodology (which they recently updated), and Grantham's latest quarterly letter:  http://www.gmo.com/websitecontent/GMO_QtlyLetter_ALL_3Q2013.pdf.  You have to register to read it, but it's a quick and painless process and well worth it.  I've attached their latest 7-year forecast.
   It's worth noting that the forecasts are in real (aka inflation adjusted) terms.  So, if we expect inflation to average 3% over the next decade, this forecast then predicts small positive nominal returns for US equities.  As you can see, none of the asset classes look attractive.  Even top performing timber is projected to return a modest 6%.  This is a result of "financial repression" and the major run-up in all asset prices over the last 4 years.

   So where should we have our money?  Grantham's forecast suggests that neither emerging market equities nor commodities are undervalued, but both areas look far more attractive than US equities.  I've been tip-toing in to emerging market equity, particularly China.  I've also been continuing to scale into commodity-linked equities.  I was a little early getting long natural gas related equities in 2012, but those are now paying off nicely, and I think the sector has a long way to run.  I'd also suggest looking at the mining and agriculture sectors.  My concern is that the credit situation in China leads to a mini-panic and sell-off in both emerging market equity and commodities across the board.  If that happens, I think both asset classes will represent a phenomenal buying opportunity.  

Cheers,
Ari