An independent professional's take on the latest news and trends in global financial markets

Jeremy Grantham lets rip

If anything Jeremy Grantham, the crusty Yorkshire-born founder of the American fund management business GMO, is even more scathing in his latest quarterly letter about the shortcomings of the Federal Reserve than Andrew Smithers was in his report I mentioned here yesterday. As always, though, he has plenty of other interesting things to say on the investment outlook as well.

This is the conclusion of his extended critique of the way that the Fed under Greenspan and Bernanke has repeatedly primed the monetary pumps to distort the workings of the normal business and economic cycle, initially with ultra-low interest rates and latterly with quantitative easing. It is well worth reading in full; you will struggle to find a better polemic on this subject.

Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing inflation fears,this easing has sent the dollar down and commodity prices up.

Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.

In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.

One of the interesting ideas in his comments on the investment outlook is the idea that there is a relationship between the Fed’s monetary policy and the relative performance of small cap stocks, via the mechanism of negative real (inflation-adjusted) interest rates.

Weaker companies need more debt. Artificially low rates that are engineered bythe Fed mean that leverage is less of a burden and survival is easier. Similarly, the Great Bailout allowed many companies that normally would have failed and been absorbed by the stronger or more prudent ones to survive.

If we look at the time frame since 2001, it is composed of two periods of negative interest rates with a bailout in between. This whole era has been artificially favorable to marginal companies and leveraged companies, partly at the expense of conservative, unleveraged blue chips.

The great companies look less excellent on a relative basis, and they have missed opportunities for picking up failing companies that they would normally have acquired at attractive prices. To see how sensitive more marginal companies are to this effect, we took a look at the effect of negative real short-term rates on the performance of the small stocks (as representatives of more marginal companies) relative to the S&P 500.

Exhibit 6 [not shown here] shows the results in an emphatic way: 100% of those four major and several minor periods of negative real rates show outperformance for the small stock group. With the Fed begging speculators to borrow at negative rates, it should not be surprising that they do, and that these speculative investments are not typically the Coca-Colas of the world.

Because of this effect, it is also probable that the regression rate of profitability, particularly for weaker companies, has slowed. This change, in turn, seems to have caused value models to work less effectively since 2001 than was the case for the prior 50 years.

This trend might help to explain why so many investors were caught out by the “dash to trash” that followed the end of the bear market in Q1 2009, and why the much-ballyhooed rotation into so-called “quality stocks” (those with strong franchises, balance sheets and positive cash generation) has not so far been as marked as many, including Grantham himself, originally expected. As a committed believer in the principle of mean reversion, he expects the latter’s time will still come (as do I).

Grantham’s quarterly letters are always feisty, thorough and well-argued, but you need to read them in full to get the most from them. Here is  a link to the latest one. On this occasion he has neatly provided his own short summary of how he sees the implications for investment strategy, from an American perspective.

1) Emphasize U.S. quality companies, which are still cheap in an overpriced world. 2) Moderately overweight emerging market equities. 3) Moderately underweight the balance of global equities. 4) Heavily underweight lower quality U.S. companies. 5) Carry extra cash reserves for a volatile market with insecure fundamentals. 6) For the very long term (20 years) overweight resources, particularly if they have a sharp decline.

Written by Jonathan Davis

October 28, 2010 at 10:37 AM