Investing When Opportunities Are Limited; Ben Inker, an associate of famed investor Jeremy Grantham, argues that both stocks and bonds are overvalued. So what’s an investor to do?

TUESDAY, JULY 23, 2013

Investing When Opportunities Are Limited


Ben Inker, an associate of famed investor Jeremy Grantham, argues that both stocks and bonds are overvalued. So what’s an investor to do?

Editor’s Note: Jeremy Grantham has decided to take a break from his scheduled summer quarterly missive to investors. But we’re happy to share the latest commentary of Ben Inker, who works alongside Grantham at GMO, the Boston-based money management firm. A longer version of this commentary, along with charts, is available on the GMO Website.

To investors focused on U.S. equities, it may be easy to forget the investing excitement of this spring, but for others, particularly anyone running a portfolio predicated on asset class correlations being low, this has been a pretty shocking couple of months. From May 22 to June 24, the S&P 500 lost 5.6%, MSCI EAFE lost 10.1%, MSCI Emerging Markets fell 15.3%, the Dow Jones/UBS Commodity index fell 4.5%, the U.S. 10-year T-Note fell 4.4%, and the Barclays U.S. TIPS index fell 7.1%. For good measure, the J.P. Morgan Emerging Debt Global index fell 10.8%, the German 10-year Bund fell 5.2%, the UK 10-year Gilt fell 3.4%, and the Australian 10-year bond fell 6.5%. Equity markets have made a fairly sharp recovery since then, with the S&P 500 actually hitting new highs, but lots of other asset classes are still licking their wounds. In light of the generally negative correlations between stocks and bonds of the last decade, the universality of the declines looks pretty weird. For those schooled in thinking that the only “risks” that matter for investors are growth shocks and inflation shocks, it’s significantly more than just weird. To anyone of that mind, it’s a bit of a soul-searching moment, and it forces you to either treat the episode as a one-off event that will hopefully not happen again anytime soon or as a challenge that requires you to rethink your risk model. Not surprisingly, at GMO we believe it to be the latter, and that most investor risk models are missing an important piece of the puzzle.This is not to say that growth shocks and inflation shocks don’t matter. They do, as they are two of the basic ways investors can lose significant amounts of money in otherwise diversified portfolios. Risk assets generally lose money in depressions, and nominal assets generally lose money in unanticipated inflations. But there is a third way to lose money, and it was what bit the financial markets in May and June. We call it valuation risk at GMO, and it is the risk associated with the discount rate on an investment rising. It can impact a single asset class for idiosyncratic reasons, but it can also affect a wide array of asset classes for a systematic reason. This spring it affected a wide array for a systematic reason.

The proximate cause of the decline was a statement given by Fed Chairman Ben Bernanke to Congress that quantitative easing would taper down within the next few Federal Reserve meetings if economic data continued to improve. Bernanke clearly did not mean for the market to freak out over the statement, as can be seen in the frantic backpedalling offered by various Fed governors, including Bernanke himself, in the following weeks. But freak out the market did, and not just one market, but seemingly all of them. Why?

If he was of a mind to, Bernanke could choose to consider the whole thing a compliment. It is only because markets all around the world have been doing what he has asked them to that his words had the impact they did. Bernanke has been quite clear that a major purpose of easy monetary policy, and quantitative easing in particular, is to prod investors to bid up the prices of assets. In this, he has succeeded, even if it has not had the knock-on effects on the real economy that he might have hoped. To understand what has gone on, it is helpful to look at our seven-year forecasts in a way that we don’t normally show them.

By pulling down both today’s cash rate and the market expectation of future cash rates, the Fed has increased the relative attractiveness of pretty much all assets other than cash and, as a consequence, their prices have risen.

Since 2009 it has been difficult to avoid making money in the financial markets. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything – has been bid up as a consequence of the very low expected returns of cash. And this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation, and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favorites.

We have known this for a while, but the trouble is that there is no easy way to resolve this problem. There is no asset class you can hold that would be expected to do well if the real discount rate rises from here.3 Under normal circumstances, a rising real discount rate would probably come on the back of rising inflation or stronger than expected growth, which are diversifiable risks in a portfolio. But May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities and other owners of real assets, but because the Fed signaled that there was likely to be an end to financial repression in the next few years. And because financial repression has pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbor from the fallout, other than cash itself.

I would like to say that having warned investors of this problem, we were able to spare our clients losses in this environment. But most of the reason we have been complaining about this issue as loudly and continuously as we have is that there is no good way out. During the market hiccup, we certainly did not do as badly as some other investors who have invested without regard to the risk of a shock to real discount rates. But to avoid taking any losses in a situation like this, you really need to know when it will occur. Avoiding losses as real discount rates rise requires sitting in cash, and we know cash offers no return today, while other asset classes are priced to give positive returns, even if lower than their historical averages. We have held more short-duration assets than normal for the last couple of years in asset allocation portfolios where that is appropriate, and that did help cushion the blow a bit, but did not save us entirely.

In honor of the currently scorching temperatures, I’d like to put our current positioning in terms of a summer camp metaphor. We’re in a canoe race to the other side of the lake. We know all of the canoes are old and a bit leaky in the best of times, and there’s a storm coming. If we knew the storm were going to break now, we’d just stay in the cabin and laugh at everyone else as they were forced to turn around and trudge back to the cabin, sopping wet and half drowned. But we don’t know when the storm will break or even if it might miss us altogether, so we’ve stuck an extra guy in the middle of our boat with a bucket instead of a paddle. We know it will slow us down, but it will go a long way to help ensure we don’t sink along the way, even if we’re resigned to the likelihood of a long slow paddle in the rain, sitting in water up to our ankles.

This might just be the cruelest time to be an asset allocator. Normally we find ourselves in situations in which at least something is cheap; for instance when large swathes of risk assets have been expensive, safe haven assets have generally been cheap, or at least reasonable (and vice versa). This was typified by the opportunity set we witnessed in 2007.

Likewise, during the bubble of the late 1990s, the massive overvaluation of certain sectors was offset by opportunities in “old economy” stocks, emerging market equities, and safe-haven assets.

However, today we see something very different. Today’s opportunity set is characterized by almost everything being expensive. This is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.

The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009:

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

Market participants have (at least until the last month) reacted to this situation by “reaching for yield.” This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices. The bad news is that reaching for yield rarely ends well.

Of course, like all of our published forecasts, the forecasts for government bonds and cash assume mean reversion. Effectively, this forecast says that real cash rates will mean-revert toward something close to long-term average, the slope of the yield curve will move to its long-term average, and inflation will move to the consensus view of long-term inflation (in the absence of a strong view on the future path of inflation). As even a cursory glance at the exhibit shows, the main driver of our negative view on treasuries is the impact of real rates normalizing from -2% to 1.6% over the course of seven years.

To convert this into a seven-year forecast we need to acknowledge the various components: the shift in the yield curve; the real yield; and the roll down (from having a 10-year bond that after one year becomes a nine-year bond, and thus to ensure constant maturity, you sell and reinvest in a new 10-year bond).

As regular readers will know, we at GMO are stalwart supporters of the concept of mean reversion in general. However, if ever there was an economic case for a question mark over mean reversion, it is surely with respect to cash rates and bond yields. The simple reason behind this seemingly heretical statement is that rates are (can be) policy instruments. As Keynes noted, “The monetary authorities can have any interest rate they like… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right… Historically the authorities have always determined the rate at their own sweet will.”

We are all used to thinking of central banks as setting the short-term interest rates, but generally the long rate is seen as a market-determined rate (i.e., some combination of market expectations of future short rates, liquidity preference, and risk premiums). However, there is nothing to stop central banks from setting the long rate as well. Indeed, in the past they have done exactly that (e.g., the UK during World War II had a target of 3% for bond yields). So bond yields can be an outright policy instrument too.

When I’m talking to people about this, it is at this point that someone usually brings up the bond vigilantes: surely these guardians of monetary and fiscal rectitude will step in. However, for a nation that can print its own currency and has a floating exchange rate, bond vigilantes are a myth – an economic bogey man made up to scare recalcitrant governments into “good” behavior.

Just imagine that I as a foreigner decide to sell my holdings of U.S. government bonds. If the Federal Reserve stands ready to buy at the same yield at which I sell, there will be precisely zero impact on yields, i.e., I sell at, say, 2.5% and the Fed buys those same bonds at 2.5%. The only impact is that the dollar will go down against the pound as I switch from holding a dollar asset to holding sterling.

This, of course, assumes that the central bank targets price (i.e., has a desired bond yield) and doesn’t care about the exchange rate. As an aside (to me, at least), one of the oddities in the process of quantitative easing is that it is “quantitative” rather than price-based. Presumably, the Fed and its brethren think they can do more than simply lower rates by using the “quantitative” approach. I’m just not sure what. To me, a combination of a price/yield target for treasuries and a quantitative easing policy for other assets (such as MBS) would be the easiest and most logical way to move beyond the zero bound on short rates. A price target is certainly easier to exit as you simply raise the yield target to your new desired level. The good news is that policy making is well above my pay grade!

An alternative argument that gets put forward is that the Fed can’t really set any rate that it likes because, ultimately, it must respect the “natural rate of interest.” One should always be suspicious of the word “natural” in the context of economics. It tends to imply some semi-divine concept, yet there are essentially no natural laws in economics.

The concept of the “natural” rate dates back to early monetary theorists but was given maximum exposure in the works of the Swedish economist, Knut Wicksell.8 However, there are several arguments that I find compelling and believe cast serious doubt on the concept of a “natural” rate of interest. The arguments over the existence of a natural rate of interest are generally what can only be described as “wonkish” 9 and thus I won’t subject the reader to an elongated discussion here.

Rather than a single, divine “natural” rate, I’d suggest it might be more helpful to think of a range of neutral or consistent rates. As Keynes put it, “It cannot be maintained that there is a unique policy which, in the long run, the monetary authority is bound to pursue.” For instance, a price stability consistent interest rate might be defined as the rate of interest consistent with stable prices (akin to inflation targeting, the darling of central bankers around the globe), a full employment 11 consistent interest rate would aim to reduce unemployment to levels that were essentially frictional, and one can easily posit a financial stability consistent interest rate that kept financial markets well-behaved.

The chance of these various rates all coinciding is essentially zero. Trying to achieve all three outcomes with a single policy instrument (short-term interest rates) is likely to be an impossible task. Thus, some political guidance as to the relative merits of the various objectives is needed, or more instruments available to be called upon.

This, of course, simplifies away from the problem of actually knowing what these various rates are. What level of rates ensures price stability? What level of rates ensures full employment? And so on. This is certainly well beyond my ken, and I suspect an unknown for the central bankers as well. To really add salt to the wound, these various rates are highly likely to be time-varying as well. Hence, trying to identify any one of these rates is akin to looking for a needle in a haystack, with the added complication that someone keeps moving the entire haystack!

Anyway, back to forecasting. The bottom line is that it is perfectly possible that the Fed, et al, could hold rates down (at both the long and short end) for some prolonged period. This is obviously an exceptionally bullish case for bonds (in fact, I’d argue it was the “best” case outcome that could reasonably be expected, absent a strongly deflationary viewpoint).

It is easiest to see how this would play out by thinking about the buy and hold return to owning a 10-year treasury. Currently, such an investment yields around 2.5% p.a. in nominal terms. If we were to hold such a bond for its lifetime, then we would simply end up with a real return equal to the current yield minus the inflation rate (say, 2.3%), i.e., close to a zero real return.

However, as noted above, if we pursue a constant maturity strategy (i.e., when our 10-year bond becomes a nine-year bond, we sell it and reinvest in a new 10-year bond), a rolldown return is created (assuming a normal upward-sloping yield curve). This would translate into a seven-year forecast in an identical fashion to that noted earlier. Effectively, rather than the -0.20 bps forecast we see under the baseline assumption of mean reversion, we would get a forecast of 2.2% per year.

This might seem like a reasonable rate of return. However, it only holds if and only if the Fed keeps rates unchanged in real terms over the next decade. As I showed in my previous work on equities under financial repression (“The 13th Labour of Hercules”), the way you behave and your estimates of return are driven by your expectation of the duration of financial repression

However, as I also pointed out in previous musings on financial repression, as far as I can tell, no one has any real idea how long the Fed (and others) will keep rates low. The market’s implied view has certainly changed radically over the last six months. In essence, the Fed spoke of “tapering” and Mr. Market heard “tightening.”

For what it is worth (and I assure you it isn’t a lot), I think that given that the Fed merely mentioned the possibility of tapering its quantitative easing policies, this seems like a probable over-reaction, especially since the Fed is explicitly following a so-called “Evans Rule” and is committed to keeping policy easy until the unemployment rate reaches 6.5% (currently at 7.5% with low participation rates) or inflation (based on the PCE) exceeds 2.5% (currently at 1%). A tapering of the quantitative easing policies seems like a very different thing than the Fed embarking on an explicit interest rate tightening cycle.

Given the massive uncertainty surrounding the duration of financial repression, it is always worth considering what happens if you are wrong. In owning Treasuries under the assumption that the Fed holds real cash rates negative, you get the roll return as above, but this could be described as a “pennies in front of a steamroller” style strategy. It is always possible that the Fed could decide to step away from the market or normalize real rates and you would end up with a return more akin to the baseline mean reversion forecast we presented above. You are effectively running a strategy that potentially has significant tail risk embedded within. One of the most useful things I’ve learned over the years is to remember that if you don’t know what is going to happen, don’t structure your portfolio as though you do!

The bottom line is that Treasuries offer low returns under most scenarios. If the Fed steps away from the market and normalizes, you get a negative return; if the Fed stays in the market, you get a pretty low return. You are pretty much doomed either way. The only scenario under which treasuries do “well” is one with outright deflation! In essence, in the absence of a strong view on deflation, you neither want to be long, nor short, treasuries. You just don’t want to own any.

I am well aware of the dangers of proclaiming the death of an asset class, because usually when this is announced, we witness an enormous bull market in the supposedly dead asset class. However, barring the deflation outcome, we could finally be witnessing what Keynes described as the euthanasia of the rentier:

“The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital… I see… the euthanasia of the rentier.”

Assuming you aren’t expecting outright deflation, then the best that can be said for owning some Treasuries is that they act as diversification/insurance in the context of an equity portfolio. However, the correlation between bonds and equities isn’t exactly stable – it wanders all over the place, and on average is positive! Certainly it is negative during a subset of events that are probably best described as deflationary busts (e.g., 1930s, 2008). So if this is the risk you are worried about, then perhaps you should own some fixed income. However, it isn’t obvious just how much of a diversifier bonds can be at very low yields.

Nor do bonds act as diversifying assets to events like the stagflation of the 1970s. Ultimately, if you own bonds as insurance you must ask yourself how much you are paying for that insurance, because insurance is as much a valuation-driven proposition as anything else in investing.

Of course, bonds aren’t the only low-returning asset class. The current opportunity set according to our forecasts is generally not compelling. To us, both bonds and equities generally look to be “overvalued.” Those focusing on the “attractive level of the equity risk premium” potentially fail to recognize this situation.

If the opportunity set remains as it currently appears and our forecasts are correct (and I’m using the mean-reversion-based fixed income forecast), then a standard 60% equity/40% fixed income strategy is likely to generate somewhere around a paltry 70 bps real yearly return over the next seven years!

Even if we used the non-mean-reversion-based forecast, the 60/40 portfolio looks likely to generate a lowly 1.7% per year real. Thus, if the opportunity set remains constant, investors look doomed to a purgatory of low returns.

So what is an investor to do? I believe there are at least four (possibly not mutually exclusive) paths an investor could go down to try to avoid this outcome:

Concentrate. Simply invest in the highest-returning assets. This is obviously risky as you become dependent upon the accuracy of your forecasts, and right now nothing is outstandingly cheap so you are “locking in,” at best, fair returns (assuming you wanted to have a portfolio that was 100% invested and split between, say, European value and emerging market equities). You are, however, giving up the ability to rebalance.

Seek out alternatives. True alternatives may be fine, but they are likely to be few and far between.

Use leverage. This is the answer from the fans of risk parity. Our concerns about risk parity have been well documented. As a solution to a low-return environment, leverage seems like an odd choice. Remember that leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one (by forcing you to sell at just the wrong point in time).

Be Patient. This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted 20 returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.

Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a repricing (witness the market moves in the last month).

Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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