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The Bear's Lair: Is rationality returning?

February 10, 2014

A return to rational concepts of valuation instead of the market’s current streak of get-rich-quick schemes might be around the corner.

Last year made bears, emerging-market investors, value investors and precious-metals investors feel like fools. The market went up continually, rising by over 30%, while stock values became ever more extended and precious-metals prices headed steadily downhill in spite of an unparalleled orgy of money printing by the world's central banks. This year, market tendencies have almost completely reversed the pattern. Is it—can it be—the return of some sort of economic rationality?

There is beginning to be some support for this idea. Bill Gross, chairman of the gigantic bond fund group Pimco, declared on Tuesday that, "the age of getting rich quick is over." He then recommended investment in 5-year Treasuries, which, given their pathetic pre-tax yield of around 1.5% (well below even the officially massaged estimate of inflation), will in general make you poor slowly. Or they will make you poor quickly if, as one might expect, inflation picks up.

"Get rich quick" has been the central investment strategy in the years of loose monetary policy since 1995. The dot-com boom focused on the most asset-light and fastest-moving parts of the tech sector. Then the housing bubble focused on massive leverage and "flipping" houses to turn a long-term asset into a speculative trading vehicle. Since 2009, money has headed into whichever sector seemed to be heading for the skies most quickly, armed with as much leverage as could be obtained from the banking system.

Entities such as mortgage REITs are built entirely on leverage. They use long-term mortgage investments financed in the short-term "repurchase" market. This allows them to raise ever-larger injections of new capital from a booming stock market to reap outsize returns from short-term rates held artificially low and a "gap" between short-term and long-term rates held artificially large.

Above all, there has been the explosive growth of hedge funds, with outstanding assets totaling $2.63 trillion in December of 2013 despite their outsized fees and persistent underperformance. Private equity funds, which totaled $3.5 trillion in assets at the end of 2013, represent another twist on the twin current investment themes of ultra-cheap leverage and short-term investment (albeit slightly longer than the trigger-finger investing of the day traders). And yet another is the perennial theme of ultra-high management fees that leave very little juice for the actual investor when long-term returns are calculated.

One form of getting rich quick, high-frequency trading, may already be in retreat. Profits are estimated to have been around $5 billion in 2009, but have shrunk since to around $1 billion in 2013. That is in large part due to volume increases that have begun to reverse while margins have been decimated with the entry of new players into the game. In September 2013, Italy—not usually a financial innovator— introduced a "Tobin" transaction tax on high-frequency trading. Its example is likely to be followed by others as the tax is found to be a "nice little earner" for state treasuries, helping to pay for the armies of financial regulation bureaucrats they are now deploying. Tobin taxes kill high-frequency trading. Its demise will not be much mourned.

"The age of getting rich quick is over" means much more than a modest dip in the stock market. It signals that all the other ways of getting rich quick, by raising vast amounts of money and deploying them in speculation, must be at an end. It must have become impossible to raise hedge-fund money without a long and impeccable track record. It must have become impossible to raise private-equity money without a strong portfolio of companies that have been turned around. Further, it must have become impossible to raise speculative second-, third- and fourth-rounds of venture capital without a solid product and a path to substantial profitability.

We're clearly not at that point yet. While speculators can raise vast amounts of money and charge massive fees thereon, it is still possible to "get rich quick," if perhaps not quite as rich and not quite as quick as a couple of years ago.

Nevertheless, if the era of "get rich quick" has not yet ended, it is nearing its denouement. At each meeting, the Federal Reserve is tapering its bond purchases by a further $10 billion monthly, already down to $65 billion in February. A Federal budget deficit of $514 billion, which the Congressional Budget Office currently expects for the year to next September 30, represents a monthly issuance of $42.83 billion. On its present schedule, the Fed will announce a reduction in bond purchases to $35 billion monthly, less than the Federal budget deficit, at its 2-day meeting ending on June 18. (Yes, I recognize that roughly half the Fed's buys are of Federal agency securities, but at that point its overall support for the long-term U.S. government bond market will have sunk below the Treasury's "draw" from that market.) That point, at which the Fed is no longer financing the entire Treasury deficit, is likely to see some hiccups in the bond markets.

The other signal that normality may finally be returning can be seen in the latest month's inflation figures and the relative strength since January 1 in the gold price (and in precious metal mining shares, an exceptionally beat-down sector.) December's U.S. producer price index was up 0.4% on the month and its consumer price index up 0.3%. That's hardly hyperinflation but it suggests that the exceptionally low inflation numbers of the last six months may be coming to an end. At the same time, while Google and Facebook's quarterly earnings were greeted with wild market enthusiasm, Apple and Twitter's were met with distinctly less rapture. A little rebalancing between the over-hyped sectors of the U.S. stock market and the precious metals sector may be a sign that rationality is beginning to return. We shall see.

A particularly important indicator will be the behavior of emerging-market share indices relative to the U.S. index and, more important, relative to each other. Unlike the S&P 500 index, up 30% in 2013, the MSCI emerging market index fell about 12%. That weakness has continued into the New Year, and emerging market shares are now trading on around half the valuation of U.S. shares even though emerging-market growth is projected to be much better.

Within the emerging markets space there is, however, a huge differential between those countries that have been well-managed and those that have engaged in a wild spending spree on the back of easily available international capital. The four BRICs were able to get money far too easily and have wasted it in socialist boondoggles in India and Brazil, megalomaniac boondoggles in Russia and, in the case of China, in boondoggles that were both socialist and megalomaniac. They deserve to have a rough next few years, as do the even worse-run polities of Argentina and Venezuela. Only a madman would invest in any of them.

However, there are emerging markets that do not suffer these flaws. First, there are emerging markets like Colombia, Malaysia and, in the last year, Mexico that up to the present have been capably run, with modest budget deficits and interest rates above the rate of inflation. While they are not perfect polities, they are on the whole better run than the U.S., Japan or most of Europe. They also have a considerable cost advantage, both directly in labor and indirectly in a relative lack of regulation.

Second, there are countries like most of Africa (not South Africa, in this respect an honorary BRIC) that are by no means well-run, but that have enjoyed a sudden access to international markets through the miracle of modern telecommunications and can now exploit the immense advantage of the world's lowest labor costs. The Nigerian oil sector, like those of Venezuela and Mexico (which may have changed since its new oil law passed in December), is suffering declining output and infinite corruption and state waste. However, everything in Nigeria except oil is growing at 8% per annum in real terms and looks likely to continue doing so.

Thus many emerging markets, whether genuinely well-run or simply very poor and enjoying new-found access to world markets, have every opportunity to continue growing, provided the world does not engage in a "credit crunch" and starve them of necessary foreign capital. There is no question that a credit crunch is coming. The mal-investment since the financial crisis of 2008 has been grotesque and continuing. However, the world's money markets are tightening only gradually, and that's not usually the signal for them to seize up.

Much more likely, they will continue to tighten at a modest pace, while inflation and precious-metals prices rise and conventionally fashionable assets enjoy increasing mal-investment. Eventually, the conventionally fashionable will suffer a downturn that is earth-shattering in its impact and lasts several years, while the over-investment is absorbed. At that point, gloom and despair will have returned to the market and emerging markets, like everyone else, will have a miserable time.

We are not at the end of the "age of get rich quick" but we may be nearing it. Even more of a relief, rational concepts of valuation may now work rather better for investors than they did in 2013.

Producer Price Index (PPI): A measure of inflation at the wholesale level.
 

Consumer Price Index (CPI): A measure of inflation at the retail level.
 

MSCI-All Country World Ex. U.S. Index: Is an unmanaged index representing 48 developed and emerging markets around the world that collectively comprise virtually all of the foreign equity stock markets.
 

S&P 500 Index: Is an unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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