Sense on Cents

Thanks to a loyal Sense on Cents reader for sharing amazing insights and perspectives from some of the best and brightest minds in the world of global finance today.

Like who? Harvard professor Kenneth Rogoff, unparalleled investor Jeremy Grantham, outspoken hedge fund manager Cliff Asness, SEC chair Mary Schapiro (ok, one exception), the extremely private but on Wall Street the extraordinarily highly regarded investor Baupost’s Seth Klarman, internationally renowned Eurasia’s Ian Bremmer, the distinguished Van Hoisington, and noted short seller Jim Chanos.

Their views were put forth at the recently completed CFA Institute annual conference in Boston. There is so much good material here that I beg readers to tag this post and refer to it often. Given the wealth of thoughtful opinion and analyses covering literally every angle of our global economic landscape, one would be hard pressed to digest and process this in one reading. Do yourself the favor, though, and revisit. The wisdom provided here is precious and not commonly found.

This commentary is lengthy but given the historic times in which we live this treasure trove is truly the best sense on cents. Share it with friends. They will thank you.

Understanding Financial Crises – Kenneth Rogoff, Public Policy Professor at Harvard
1. Global deleveraging eventually has to take place, which will weigh on global growth for the next decade

2. No one really knows the future implications of an enormous moral hazard (too big to fail) problem that we currently have throughout the world.

3. If you think the shock and awe bailout solved the Greece problem, you are crazy.

4. He does not think the Euro/EU eventually collapses, but he does think some members will eventually have to be kicked out.

5. There is plenty to debate on the ramifications of the US response to the crisis, but thus far our response has been almost identical to that of Japanese government (as opposed to Sweden’s). Japan does have some more challenging structural issues (demographic, cultural, political, etc.) than the US, so we do have a better chance of eventually digging ourselves out…but near-term ramifications are likely to be similar to what Japan experienced.

6. He is bullish on China over the next century, but those who think they can sustain 6-10% growth over the next decade are wrong. He thinks a correction of 2-3% growth, if not contraction) is inevitable and will be very painful for certain pockets of the global economy.

Jeremy Grantham
1. Discussion about ethical deterioration in our business over last 25 years. Much had to do with investment banks going public and then enacting all kinds of businesses (prop trading one example) that no longer put the client first. We (investment management) allowed this to happen by continuing to give our business to the worst perpetrators.

2. He seems to be in the inflationary camp and specifically mentioned timber as one area of large investment for them.

3. He hates gold, but bought some last Friday. He hates it because of his history trading it and the difficulty in building a fundamental case. He said there are 18 different well thought out theories at any given time on gold, some making a great case to own, some making a great case not to own. He said he finally bought some because historically it has always gone down after he bought it and he was tired of seeing it go up.

4. He asks room how many expect high inflation within 4 years? 90% of room raises their hand.

5. He makes compelling case for 4-5 year deflationary period. Key points are:
How long has it historically taken to get from 75% utilization to 80% utilization (which is where we need to be before aggregate supply curve has a slope to it)? About 5 years.

6. According to Minsky, we have been in a ‘Ponzi’ finance cycle since 2000.

7. People worry about massive amount of public debt, however, the private sector debt dwarfs public debt and the private sector continues to deleverage rapidly.

8. Reason Fed can’t get the ball rolling is the money multiplier (not V, velocity, multiplier is number of times M1 gets converted into M2) is decreasing (Fisher’s theory of debt deflation). Why hasn’t M2 grown despite all the M1 pumped into the system? The Fed can’t force the banks to lend.

9. Even if M2 is just barely growing, this should still lead to some modest inflation if V was stable. It is likely to continue moving down. First, it displays a reversion to the mean behavior historically and we are currently above the mean. Second, V has historically increased as results of either increases in financial innovation or leverage. We are at the end of a cycle on both fronts.

10. There are numerous academic studies that show government spending has had a minimal impact on the multiplier. After you weigh in the negative impacts of the tax multiplier, it is clear they cannot artificially shift the demand curve. They are doing everything they can to inflate, but the reality is that the Institution is not as large as the System.

11.He does not see the Fed tightening for a decade.

12. He repeatedly used a 17% unemployment figure in his comments. Question was how do you trust what the government tells us the inflation rate is in CPI when you don’t believe their numbers on unemployment? His answer is he is aware of the weaknesses of all the inflation calculations, but all you have to do is look at the slack in the system to realize we don’t have inflation.

A Survey of Hedge Funds, with comments on financial regulation – Cliff Asness – AQR Capital Management
1. He was somewhat critical about some hedge fund practices, especially the pre-2008 world.

2. A shakeout was due and healthy for the industry. The 2 and 20 model across the board is dead and will only be available going forward for a small minority of managers.

3. Hedge fund registration is definitely coming and a good thing in his opinion. Transparency in general must improve.

4. Hedge funds will continue to play a very of important role in asset allocation.

Questions that Keep a Bond Manager Up at Night – Dan Fuss of Loomis Sayles, John Malvey of Global Capital Markets, and Bill Nemerever of GMO
1. On GDP growth, one said 0% growth and deflation, one slow growth (1-2%), and one said slow growth in US, but strong growth in Asia.

2. 2 of 3 were bullish on growth in Asia. GMO guy said he aggress with Ed Chancellor.

3. All were in camp of deflation for a few years, then high inflation eventually.

Mary Schapiro – Chairman SEC
1. She was scheduled to be in Boston, but had to do her presentation via video feed from Washington. Flash Crash has been keeping her busy.

2. Her presentation was a typical Washington bureaucrat speech, with nothing said of any value.

3. Some tidbits that came out of Q&A were:
>SEC staffing & budget are just now back to 2005 levels.

>She just mentioned that official discoveries on flash crash and some new circuit breakers and speed bumps would be announced later in the day. It will take much longer to be able to pinpoint exact cause.

>Would not speak to Goldman case, but seemed to suggest lots more lawsuits coming beyond Goldman.

>On OTC derivatives, they must come into the regulatory umbrella. They need a clearinghouse, better transparency, etc.

>She supports the consumer protection agency formation

>They are coordinated with the UK on hedge fund regulation and expect registration and other forms of regulation for the industry.

Seth Klarman – Baupost – a full 70 minutes of him answering questions from WSJ’s Jason Zweig and the audience
1. How do you follow/deviate from Graham & Dodd?
We follow them from the standpoint of how we think about investing rather than specific process application. For example, we believe in diligently searching for bargains. The specific way to go about it has changed because the world has changed.

2. What did you learn working with Mike Price?
He would tirelessly keep pulling threads on an idea. He was very passionate about the pursuit of a good bargain.

3. What went wrong with traditional value investing in 2008?
There are many short-term periods historically where value had significantly underperformed, however, value still shows that it outperforms in the long-term. That said, many public stocks had become LBO models in the pre-2008 world. Equity investors needed to be more nimble in quickly linking the connection of many of these publicly traded equities to the mortgage crisis. Credit was not a focus of equity holders, it was more on the peripheral. There was also the ever-present pressure by active managers to hold the least objectionable stocks.

4. Regarding the part in “the Big Short” where Burry is defending his correct bet to his investors…how do you deal with short-termism with Baupost clients?
We have been very picky with our client base. That is extremely important to being a successful investor. We require that our clients 1) be in general agreement with us when we think we have had a great year, and 2) be the type of client that likes getting a phone call from us giving them an opportunity to add capital at what may seem like the worst possible time.

5. In early 2009, you went from zero exposure to half of your fund in residential mortgage related securities…how did you react so quickly when everyone was frozen with fear?
We have the right people at our firm that think about the world in the same way. We also do not organize our analysts by sector coverage, but by opportunity type (asset class, special situation, etc.). That way, we are not wasting time following the quarterly earnings of companies that we are unlikely to every own anyway.

6. You make it sound easy…was it really that easy sitting in your seat in early 2009?
Yes. If you have done your work, you have more conviction in your analysis than what the market is telling you. The panic comes from low conviction investing…worrying about what the other guy is doing, i.e. CNBC and Cramer style of investing. There is too much arrogance in investing. Successful investing requires humility. It is that humility that causes you to require an adequate margin of safety. With that margin of safety in hand, you are allowed to be more confident when the market tests you.

7. You were critical of index investing in “Margin of Safety”. Do you still feel that way…even if we are talking about your average middle class investor? Yes, it is still a horrible idea. I am more likely to buy a stock that gets kicked out of an index. You are likely to get low return on a public equity  investment at today’s entry point (just like over the last decade). There are times when other asset classes are far more attractive.

8. You said last year that we were in a Twinkie Market…what did you mean by that?
There was/is nothing natural in the markets (the government actions have been controlling everything). The Government has clearly wanted people to buy equities. I am worried what would happen if these manipulations went away. The degree of involvement in still growing. It seems that the government has been in the business of giving bad advice. “I am more worried about the world broadly than ever before in my career”.

9. What do you worry most about?
I worry that the dollars we make may not be worth anything. I worry about all paper money. I worry that the past of least political resistance is to inflate and debase the currency. I remain optimistic, however, that we can change directions politically. At some point, making the tough decisions could also become the right thing to do politically. We could see more Scott Brown’s come along.

10. How do you feel about commodities?
To us, it is speculating. The line I draw in the sand is future cash flow. Land is the tough one, but gold to me is clearly just speculation. I am not saying I absolutely would not have any exposure to gold because of my concerns about paper money. If I bought gold, it would be for a portfolio hedge, however, when you are hedging you look for inexpensive ways to hedge. There are other ways to hedge inflation. For example, we have purchased way out of the money puts on bonds as inexpensive portfolio insurance. We are 30% cash right now. We will have no lock-up for our clients after this year.

11. How do you avoid group think?
It is something we constantly ask ourselves. For example, we just had an offsite where we had several very smart people come in to speak to us…it concerned us how unanimous the opinions were on the big problems currently facing the markets. One thing we do that is different from other active managers is we take the view it is never the analyst’s fault. We believe that we are all (the analyst, PM and myself) equally responsible for each idea.

12. Could you offer a specific investment idea you currently see as attractive?
We are currently buying commercial real estate (private stuff only). The public market REITs are quite unattractive on valuation, but there are opportunities in the private market.

Ian Bremmer – Eurasia Group
1. Message for investors is expect far greater likelihood of fat tail events

2. N. Korea – whatever risk probability you assigned to N. Korea six months ago, you should now increase. Recent actions (bombing S. Korean vessel) are very troubling. Why would they be doing these things? Answer: they are financially desperate and are now even more of a wildcard.

3. China – US multinationals have not figured out the reality of operating in a state run capitalist country. They need to realize as soon as there is a legitimate Chinese alternative to their service or product, it is game over for them and they will be ‘googled out’. Certain industries, however, are well positioned because China is a long way from being able to offer something comparable, i.e. health services for example. Anecdotal story of meeting with Chinese finance minister about a year ago to demonstrate how far apart they are from the west in terms of how they see the world…first question after they sat down – “Now that the free markets have failed, what is the appropriate role for the state?”

4. Prepare for capital flowing more regional than global going forward. Politicians realize that if their economies go down, they are vulnerable. Thus, they must scapegoat…and that is what they are going to do.

5. US – he thinks Obama’s ability to set the national agenda is amazing. Be prepared that if Democrat losses are not as bad as predicted, we see massive tax increase and new social program legislation passed in December.

6. Obama has no foreign policy. There is no Obama doctrine other than to react to crisis.

7. Claims that Obama is a socialist are overblown. He is likely to make us look a lot like France at the end of the day (I guess that is supposed to make us feel good).

8. Iran – he thinks Iran getting nuclear weapon capability is inevitable, but they will not test it like N. Korea. All countries have realized we are going to have to live in a world where Iran has nuke capability. US/Israel relations are the worst they have ever been. There is a zero percent change of a pre-emptive strike by US.

9. When asked will there be a WW III between US and China he said he does not see that scenario. He thinks a military conflict between India and China is a far more likely scenario.

10. Off the radar event to watch is Russian Olympics…risk of a big terrorist attack is high.

Van Hoisington – Hoisington Investment Management
1. He asks room how many expect high inflation within 4 years? 90% of room raises their hand.

2. He makes compelling case for 4-5 year deflationary period. Key points are:

>How long has it historically taken to get from 75% utilization to 80% utilization (which is where we need to be before aggregate supply curve has a slope to it)? About 5 years.

>According to Minsky, we have been in a ‘Ponzi’ finance cycle since 2000.

>People worry about massive amount of public debt, however, the private sector debt dwarfs public debt and the private sector continues to deleverage rapidly.

>Reason Fed can’t get the ball rolling is the money multiplier (not V, multiplier is # of times M1 gets converted into M2) is decreasing (Fisher’s theory of debt deflation). Why hasn’t M2 grown despite all the M1 pumped into the system? The Fed can’t force the banks to lend.

>Even if M2 is just barely growing, this should still lead to some modest inflation if V was stable. It is likely to continue moving down. First, it displays a reversion to the mean behavior historically and we are currently above the mean. Second, V has historically increased as results of either increases in financial innovation or leverage. We are at the end of a cycle on both fronts.

>There are numerous academic studies that show government spending has had a minimal impact on the multiplier. After you weigh in the negative impacts of the tax multiplier, it is clear they cannot artificially shift the demand curve. They are doing everything they can to inflate, but the reality is that the Institution is not as large as the System.

3. He does not see the Fed tightening for a decade.

4. He repeatedly used a 17% unemployment figure in his comments. Question was how do you trust what the government tells us the inflation rate is in CPI when you don’t believe their numbers on unemployment? His answer is he is aware of the weaknesses of all the inflation calculations, but all you have to do is look at the slack in the system to realize we don’t have inflation.

5. What about global commodities impact on inflation?
He agrees with Milton Friedman on commodities in that 1) they are a small piece of the mix, and 2) if individual commodity prices go up, something else is going down to more than offset.

6. How will you know if you are right or wrong?
Track M2. It comes out weekly. If banks start lending and M2 starts growing, then its time to worry about inflation.

Jim Chanos – Kynikos
1. Went through typical arguments for why short selling is important and necessary.

2. The “Blame the Shorts” mentality when markets go down has been around throughout history.

3. German ban on short selling (just announced before he spoke) – As I understand his explanation, it is a requirement for a hard pre-borrow…meaning your prime broker must have your shares located and in your account before you can short. He expects all of Europe to adopt the same rule. It does not impact fundamental shorts like him, but a big problem for short trading strategies.

4. He recommends not talking to management (whether you are short or long). It is easy to discover the bull case on any stock, you don’t need management telling you what they have already told the brokers which they regurgitate daily. He cited two surveys (one in Business Week and one on CFO magazine) where they anonymously asked CFOs if they had ever been asked by their supervisor to materially misstate the books…2/3 answered that they had in both surveys.

5. Always think about who is taking the other side of my trade.

6. Kynikos uses 3rd party research, a lot of it accounting focused.

7. He highlighted their major short themes: Booms, Consumer Fads, Technological Obsolescence, Accounting.

8. Most profitable theme has been techno obsolescence – he cited he internet and anything that can be distributed digitally at an incredibly low cost…cited music retailers, video retailers, and currently short Netflix, which he admitted has been wrong, but he said don’t worry, he will eventually be right.

9. On accounting, he likes the tactic of when a company makes an acquisition they have the opportunity to right down assets between what was on last 10Q before transaction and at time when transaction closes…ask the company if net assets of the acquired company are the same as reported in company’s last 10Q…if not, short the stock.

10. Spent very brief amount of time on China – Only threw out statistic that currently there is $30B sq ft of commercial real estate under construction…that is a 5×5 ft cubicle for every man, woman and child in China.

11. What about global commodities impact on inflation?
He agrees with Milton Friedman on commodities in that 1) they are a small piece of the mix, and 2) if individual commodity prices go up, something else is going down to more than offset.

My friends, this is about as good as it gets. I am indebted to our loyal reader for sharing this “inside baseball” navigation of our global economic and markets landscape.

LD

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