Last Wednesday Jamie Dimon, CEO of JP Morgan Chase, threw an idea at conference attendees that made them sit up and take notice. He said that earlier in the year he had worried by the dark clouds on the horizon, but then the clouds darkened, and now they have built up to the point where we face a hurricane. (seekingalpha.com/article/4515787-jpmorgan-chase-and-co-jpm-ceo-jamie-dimon-presents-bernstein-38th-annual-strategic-decisions)
Some of his worries:
“I'm prepared for a non-benign environment by the end of the year…we will be prepared for bad outcomes.”
The interviewer then asked about the degree of difficulty of the task at hand in front of the Fed right now? Related to which were Dimon’s previous comments about storm clouds.
“I'm going to change the storm cloud because I said there were three things that we're going through, which are, I hate the word unprecedented, which are kind of unprecedented.
“And when you're seeing things that have never happened before, then you have to question your ability to predict."
Number one – too much stimulation
“One is huge growth in this country driven by fiscal and monetary stimulation. That isn't a normal recovery, okay, and that fiscal stimulation is still in the pocketbooks of consumers, they're spending it, they're spending at very strong levels. And the data is completely distorted. It's distorted by inflation…but jobs are plentiful, wages are going up, consumers are spending - the lower-income folks, not quite as much as before - but everybody else it looks like they have $2 trillion dollars more. [There’s been a] savings rate drop.
“I don't think that's going to stop their spending in six or nine months. And so, that to me is the bright clouds out there or -- but it's different.”
Number two – the response of raised interest rates on short and long term borrowing is full of risk
“The Fed has to meet this now with raising rates and QT [Quantitative Tightening – Central Bank ceasing to buy longer dated bonds and even selling them into the market]. And the new part of this isn't the raising rates, it's the QT.
“We've never had QT like this. So, you're looking at something they could be writing in the history books on for 50 years; what was QE, what worked, what didn't work?
“I think a lot of parts of QE backfired. I think the negative rates was probably a huge mistake for a whole bunch of different reasons I won't bore you with now.
“But they’ve got to raise rates, and mind you, they have to do QT. They do not have a choice because there's so much liquidity in the system; they have to remove some of the liquidity to stop the speculation, to reduce home prices, stuff like that.
“That's a huge change in the flow of funds around the world. I don't know what the effect of that is -- and you're talking about minimum huge volatility.”
Number three – war can have massive consequences
“And the third thing is Ukraine; that you've not had a European land war since 1945, okay. And the complexity of Ukraine is we don't know the outcome.”
“I always make a list, you know, you predict the outcome. Well, you couldn't predict the outcome of Vietnam, Korea, Afghanistan, Iraq, and 10 other conflagrations; all wrong.
“Wars go bad. They go south, they ha.....
Martin Wolf, the Financial Times’ associate editor and chief economics commentator, is worried that the Federal Reserve of the US has allowed inflation to get out of control; bringing back to earth will be painful. (His article was titled The Fed must act now to ward off the threat of stagflation (Financial Times, May 24 2022)
He starts by asking if we are moving into a new era of higher inflation and weak growth, similar to the stagflation of the 1970s? He writes, “The similarities are evident between the present ‘surprise’ upsurge in inflation to levels not seen in four decades and that earlier era, when inflation was also a surprise to almost everybody, except the monetarists. That era was also characterised by war — the Yom Kippur war of 1973 and the invasion of Iran by Iraq in 1980. These wars, too, triggered jumps in oil prices, which squeezed real incomes. The US and other high-income economies experienced almost a decade of high inflation, unstable growth and weak stock markets.”
By 1980 US inflation was over 14%. It was brought under control by Paul Volcker, chair of the Federal Reserve, through very painful rises in interest rates -up to over 20% - leading to recession 1981-2. Unemployment rose to over 10%. The stock market fell into bear territory.
This is taken from the history section of the Federal Reserve website: “[Volcker] believed that the Fed faced a credibility problem when it came to keeping inflation in check. During the previous decade, the Fed had demonstrated that it did not place much emphasis on maintaining low inflation, and public expectation of such continued behavior would make it increasingly difficult for the Fed to bring inflation down. “[F]ailure to carry through now in the fight on inflation will only make any subsequent effort more difficult,” he remarked in 1981.”
The noise around the Fed’s "credibility problem" in 2022, with inflation now over 8% is going to get louder and louder. It will do so until they act harshly to prove they are not soft on the problem.
On 31 May President Biden met Jerome Powell of the Fed to express his support for any toughness he might think necessary to deal with inflation. The President said he would give the Fed “the space they need to do their job, adding, “I’m not going to interfere with their critically important work.”
Martin Wolf points out another similarity with the 1970s. That is, the rise in inflation was, and is, blamed on supply shocks caused by unexpected events. But that was not the only, or even the main, factor either then or now. This main issue is the pumping up of demand from American consumers for goods and services caused by the vast amounts of hand outs from government and very low interest rates.
“Excess demand causes supply shocks to turn into sustained inflation, as people struggle to maintain their real incomes and central banks seek to sustain real demand.”
There comes a point when policymakers realise that if they keep pumping up demand all that will happen is that inflation goes higher and higher. When they, rightly, stop the boosting incomes fall or stagnate. At the same time the momentum in inflationary expectations cause prices to keep on rising at unacceptable level. Then we have for a while “StagFlation” – at the same time as the economy has stagnated, inflation still rages.
“This then leads to stagflation, as people lose their faith in stable and low inflation and central banks lack the courage needed to restore it.”
It’s Martin Wolf’s view that US equity investors have not yet cotton-on to consequences of the stagflation scenario:
“At present, markets do not expect any su.......
Ray Dalio is an American billionaire investor and hedge fund manager, He founded Bridgewater Associates in 1975 in New York.
(The following quotes are my transcript of an online discussion he had with Jeremy Grantham (19th May Ray Dalio and GMO's Jeremy Grantham on How They're Seeing the World Right Nowhttps://www.youtube.com/watch?v=-qD4kqAarec)
We have been living in false paradise…
“This is the third year of the expansion with very aggressive monetary policy. So we’re in the part of the typical expansion where there’s a lot of inflation pressures because it happened in a giant, big way. It’s the end of a paradigm because everybody believes that they want everything to go up.
“And, of course, that creates a dynamic where policy is long (everything goes up). And, of course, that happens by creating money, credit and debt.”
Those who thought their financial claims will buy increasing amounts of real goods and services will be disappointed…
“Financial wealth has become enormous relative to the real wealth – everybody who was holding bonds or financial assets (they are just journal entries, they’re claims) in general believes that they can take that buying power and sell it and buy goods and services. And they can’t. And by necessity there must be real negative returns relative to buying power.”
High interest rates squeeze equities…
“So we’re now going to be in a very tight e
Jeremy Grantham, a Brit from Doncaster (and Sheffield Uni) who made it very big in America through his deep understanding of markets (co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO) in Boston), spoke a week or so ago about his sense of trepidation regarding the US equity market (see "Ray Dalio and GMO's Jeremy Grantham on How They're Seeing the World Right Now" https://www.youtube.com/watch?v=-qD4kqAarec).
He said he was surprised to find himself in the third great investment bubble of his career,
“basically in the US the market is showing signs of breaking down...the worst opening for the year for the S&P since I was one year old in 1939. The Nasdaq is down 27.5% from its high, Russell 2,000 about -23%. So, it’s getting to be interesting; Bitcoin is down…meme stocks in ragged diasarray.”
His knowledge of financial history, and especially of bubbles, leads him to declare that this is “the real McCoy; it seems to be playing out pretty close to 2000”.
The three great bubbles in the US in the last one hundred years (1929 in shares, 2000 in shares, 2006 in housing) have common characteristics that separate them from more ordinary bull markets apart from the extreme valuations relative to income received on the underlying assets.
“great bubbles…are characterised by nearly hysterical behaviour, really seriously weird over-optimism, which is very rare. Which are characterised by accelerated price moves on the up side; and by a weird deviation on the up side between the blue chips going up and the risky stocks going down. And that is rare as hens teeth. It happened brilliantly in ’29, it happened during the year 2000 again in spades with the S&P ex-growth continuing to go up through September 2000 and the growth stocks going down basically 50% and the internet stocks dropping maybe 60 – 70%.”
He observes the same today, “and we saw a very handsome deviation between the S&P rising last year and the Russell dropping quite handsomely. So there was a 20 – 25 percentage point spread on the up side. And that for me is a pretty good indicator.”
So why is it that the riskiest shares fall first. It’s mostly to do with the incentives for fund managers to stay invested in shares. They recognise the dangers market-wide but see some areas as less vulnerable to very large falls in a downturn. If they invest in those, yes, they will experience share price falls, but not as much as if they were hold say unprofitable tech shares. Therefore relative performance looks good – they’re down say 10% when other investors are down 20%
“And I’ll tell you what this describes. It describes Mr Prince’s “I’ve got to keep dancing, because the music’s still playing” – We understand that completely; the enormous commercial imperative of the industry to play up to and over the edge”.
[Chuck Prince, Citigroup CEO, told the FT in July 2007 that he recognised that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market. He said “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”]
Grantham said that investors are not complete idiots so they say “’Well, I’ve got to keep dancing. But I don’t have to keep dancing with Pumatech (the most advanced stock in 1999). I’m going to transfer to Coca Cola. And I’ll keep dancing off the edge, but I’ll go off with Coca Cola.’ And it works. The Coca Cola’s are maybe handsomely overpriced, but in 1929 and 2000 they always go down a lot less as the bubble breaks. And that’s the phenomenon that causes this very rare indicator of impending doom, which we saw last year.”
The confirmation of the presence of this tendency in the markets today along with numerous other indicators, just like in 1929, 2000 and 2007, convinces Grantham that “this was not only the real McCoy bubble…[but] I believe the declines will be very substantial.”
So what form will the downward turn take?
“We have a market today which feels superficially like 2000. And I
At the Davos conference last week George Soros read a speech entitled “The fight of our lives”.
He started by noting that the course of history had been changed dramatically by Russia’s invasion of Ukraine – there is no going back, it “may turn out to be the beginning of World War III, and our civilization may not survive it.”
Soros grew up in pre-war Hungary in a time of stability or “equilibrium”. Then Hitler invaded resulting in “a far from equilibrium situation”, this was followed by a second far from equilibrium state when Communist Russia took over.
Now in his 92 year, the way he sees it is that, 70-odd years after WW2:
“The world has been increasingly engaged over the past half-decade, or longer, in a struggle between two diametrically opposed systems of governance: open society and closed society. In an open society, the role of the state is to protect the freedom of the individual; in a closed society, the role of the individual is to serve the rulers of the state.
It is because we might have to engage in this struggle that we become distracted from other issues of great concern, that is “fighting pandemics and climate change, avoiding nuclear war, maintaining global institutions…That’s why I say our civilization may not survive.”
As well as the leaders of the two big autocratic states joining together to challenge the west’s open societies we have the problem of the Omicron variant spread through China.
“Xi persists to this day with his zero-COVID policy, which has inflicted great hardships on Shanghai’s population by forcing residents into makeshift quarantine centres instead of allowing them to self-quarantine at home. Shanghai’s inhabitants have been driven to the verge of open rebellion.
“Many people are puzzled by this seemingly irrational approach to the pandemic, but I can give you the explanation: Xi harbours a guilty secret. He never told the Chinese people that they had been inoculated with a vaccine that was designed for the original Wuhan variant of the disease, but which offers little protection against new variants.
“Xi cannot afford to come clean about this, because he is at a very delicate moment in his career. His second term in office expires this fall, and he wants to be appointed to an unprecedented third term and eventually become ruler for life. He has carefully choreographed a process that would allow him to fulfil his life’s ambition, and everything must be subordinated to this goal.”
National pride, and Xi’s stubbornness, mean that the RNA-based western vaccines are not welcome. This is likely to mean millions of deaths if lockdowns are relaxed. Given the high transmissibility of Omicron the disease is not going away, thus lockdowns will continue.
Both Putin and Xi, rule by intimidation:
“And as a consequence they make mind-boggling mistakes. Putin expected to be welcomed in Ukraine as a liberator; likewise, Xi is sticking to a zero-COVID policy that can’t possibly be sustained.
“The continuing lockdowns have had disastrous consequenc..........
..In yesterday’s newsletter I outlined some of the dangers facing the world of finance. We need to ask if the dangers have arisen in a time of modest asset prices and therefore there is some resilience in the system to absorb such shocks? Or are they hitting us at the point when markets are priced for perfection, e.g. investors price shares on the basis that the Fed will serenely calm down inflation without upsetting anybody by say raising unemployment, an “immaculate deflation”.
Analogy: The film The Italian Job ends with the bus full of gold teetering on the brink. All it needs is for a trigger such as an ounce of extra weight at the wrong end of the bus for it to plunge into the ravine.
So the question for us today is whether we focus on the trigger or we focus on the factors that led to a precarious position?
Of course, when the trigger arrives - say the shutdown of one-quarter of China’s factories - all attention will be on that trigger. But the trigger is only one-tenth of the story; it wouldn’t matter so much if markets are modestly priced now - if Wall Street was not priced for perfection.
We need to focus on the level of resilience (are we on rock solid ground or teetering on the brink?) especially when there are so many potential triggers out there. That brings us the CAPE.
Benjamin Graham made great use of the cyclically adjusted price earnings ratio, CAPE, to judge, in a rough and ready way, whether a company was grossly over or under-priced.
Robert Shiller of Yale university built on the idea of looking at asset prices relative to earnings over a full economic cycle by calculating the CAPE for the American stock market as whole for every month going back to 1881.
His data has been used by people to get a first approximation to whether we have “high” or “exuberant” markets, or “low…depressed” markets.
Thus, if the CAPE is at say 30 the average share is 30 times the average annual earnings of the companies it represents when averaged over the previous 120 months.
A better way of thinking about that is the average share offers a 3.3% earnings yield. This is on the assumption that earnings in future years will be the same as the average over the last decade.
Of course, at times like these the optimists come to the fore and declare that it is OK to pay 30 times average earnings because profits are on an upward trajectory, “soon they will be double the historical level” and so the one-year PER, at least, will fall to “only” 15, an earnings yield of 6.7%. So that’s OK. Times are good and earnings will double, won’t they? And 6.7% earning yield is a good return, isn’t it, even for the risk we run by holding the risk capital assets called shares”?
Well, history has shown us that people have a remarkable propensity to shift mood. They can start to think that far from earnings doubling they will actually keep falling year after future year.
And far from thinking 6.7% is a good return they think that it’s far too little given higher inflation and given the terrible risk they face with shares, where you can lose 20%, 50% or 70% in a short period – many people are already starting to think “I lost 25% on my US tech stocks over the last six months. Of course, shares are risky. Give me more return or I’ll sell them.”
This shift to a negative mood in the past has resulted in stock market participants being so fed up that the CAPE on the averagely risky US fell to 8, or even as low as 6.
Evidence of CAPE’s usefulness
But enough of moods. What of the evidence of the usefulness of the CAPE in predicting future markets. The academic work on the aggregate market CAPE shows that if you allocate each year of stock market history to one of ten categories depending the level of CAPE, so the top decile contains the one-tenth of years with the highest CAPEs and the bottom decile the one-tenth with the lowest CAPEs, then a remarkable result is shown for stock market performance in subsequent years, at least on average over a large sample.
For example, in the study conducted by Rui Antunes the return from the high decile CAPE stocks (using the world index) over the next year was -4% whereas that from the lowest CAPE decile was +21%. Now, this was one study over one time period so caution is needed. But the results do fit into a general pattern in the literature.
The CAPE is far from a “perfect predictor”: in 1997, for example, and again in 2018, the US CAPE was very high and yet shares went up the following year.
While not a perfect predictor we can conclude that in general terms if the CAPE is very high shares have an increased probability of falling over the next few months or years, or at least providing a poor return.
Some past extremes
In September 1929 the US stock market reached a CAPE of 32.6, a peak it wasn’t to surpass for another 68 years.
Come June 1932 investor mood, not helped by the economic environment, had shifted so much that investors were willing to pay an average CAPE of only 5.6. In other words, as investors looked back at ten years of earnings (1922 – 1931) they thought either that the next ten will be worse or that, because of the increased perceived risk, they’ll demand a 18% (1/5.6) earnings yield based on the previous decades’ earnings.
For a couple of generations investors were so fearful of equities that they kept the US CAPE low. The next peak did not come until 1969 when it rose to 22.3. That was thought by many at the time to be a wildly optimistic valuation.
Then the downturn came in the 1970s pushed by stagflation. The CAPE fell to 8.3 in 1974. This came about through massive share price falls. (It created many opportunities for value investors).
The market recovered and by the 1980s one-year PERs and the ten-year CAPEs were back into double figures.
Later a mania for dotcom stocks chan.........
Some serious thinkers, with hundreds of years observing markets between them, have recently become pessimistic about the state we are in. They have – independently and in different forums - spoken out in the past week or so. The fact that so many people whose intellect I greatly respect are all pessimistic at the same time is worrying, especially when combined with my own reading of the economic runes.
Each choses to highlight a different main problem/trigger, but all acknowledge a general background of excess, market fragility, policymaking incompetence and sense of the coalescing of multiple dangers creating a looming turning point in history.
What we have got coming may be no normal downturn. These people, whose ideas I’ll try to set out in a few newsletters, point to a set of negative events that could be on a par with some of the worst financial experiences of the twentieth century.
Their ideas resonate with the conclusions I’ve been drawing from my general reading of economic and financial market conditions over the last five months. As a result I sold off about 30% of my equities early in the year. Now I’ve sold some more some more shares (MS International in this case) so that I have more cash to, hopefully, (a) out-perform on the way down simply by not having so many shares, and (b) buy bargains when the negative impacts have been recognised by Mr Market – he is likely to go into a very poor state of mind when the recessions and other strife become truly visible.
There’ll be some rules to follow in troubled times, the key ones being:
George Soros, at Davos last week, said we m.....
I'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk
investing is about making the right decisions, not many decisions.