Grantham, High Yield, and The Cyclical Bear In Gold – CMG Capital Management

“If you’re young, take the whack [and] if you’re old, pray for the Fed to keep going.” – Jeremy Grantham

Grantham was the opening keynote at the Morningstar, Inc. (NASDAQ:MORN) Investment Conference in late June. There were several notable insights I share with you this week. The intro quote above pretty well sums up his outlook. All about that (bass) Fed, about that (bass) Fed. The jingle continues to ring in my mind.

I believe the high yield debt market can help us identify market inflection points. High yield tends to be a leading market indicator. A default wave is in our near future and I suspect the opportunity it will create may arrive sooner than many expect.

I’m not sure if you saw the recent heated debate between BlackRock, Inc. (NYSE:BLK)’s Larry Fink and the great Carl Icahn. It was about the potential illiquidity in fixed income ETFs. Icahn said, “There is no liquidity. That’s my point. And that’s what’s going to blow this up.” I’m grateful for all Fink has created but put me in the Icahn camp on this issue. My two cents is the inherent problem will be one of the driving sources of the great future opportunity.

It is estimated that nearly three quarters of U.S. investment wealth will be in the portfolios of pre-retirees and retirees by 2020. While the younger investor can “take the whack”, the pre-retiree and retiree can’t. Ten years recovering from decline is different for a 45 year-old than it is for a 65 year-old. “Pray for the Fed to keep going”- indeed.

Another storm is ‘a brewing. Yet, we don’t need to take the whack. As was the case in prior overvalued, over-leveraged and aged bull markets, the game for now is to participate and protect.

Let’s also take a look today at what is going on in high yield bond market. I believe it can tell us a great deal about the timing of future opportunities.

Included in this week’s On My Radar:

• Grantham – Keynote Highlights (Morningstar Investment Conference)
• What Do High Yield Maturities Tell Us About Timing the Credit Cycle? GMO’s Ara Lovitt
• Gold – What to do with Gold
• Trade Signals – Zweig Back On A Buy, Trend Remains Positive, Sentiment Bullish – 07-22-2015

Grantham – Keynote Highlights (From the Morningstar Investment Conference)

• Equity valuations are heading toward the “two-sigma” level that is the requisite threshold for a true bubble (referring to a 2 standard deviation move from its long-term trend)
• A “trigger” will precipitate the reversion back to the mean levels
• He said, “The market is driven by career risk where investors’ job descriptions are to keep their jobs. They deal with the mindset to “never be wrong on your own” and if you are going to be wrong, make sure you have plenty of company.” This process guarantees that investors herd together and drive asset class valuations way beyond fair value.
• GMO’s seven-year forecast assumes valuations will normalize over a seven-year time horizon, with both lowered profit and PE levels.
• GMO is forecasting a -2.3% seven-year return for U.S. large-cap stocks.
• In order for equity yields and returns to increase, “we have to take a hit because the market is overpriced”
• A younger investor with less accumulated assets will benefit more than an older investor with more accumulated assets
• Government policies have prevented capitalism from working in normal ways
• Fed policy has fueled high margins, a stock-option culture and a fixation on short-term results
• 30 years ago, 20% of senior management pay was attributed to stock options; today it has exploded to 80%.
• In line with this incentive, corporate management teams have chosen the much less risky path of stock buybacks to drive valuations and profitability. It is easier for corporations to meet their quarterly numbers through stock buybacks than it is through capital investment.
• The pace of stock buybacks has accelerated dramatically and is at a record annualized rate of $700 billion per year to date while capital spending is 4% below average even after a six-year recovery with record profit margins.
• This is a high price to pay to make senior management rich and the lack of capital spending is a drag on economic growth. Management teams are more comfortable buying back stock, pushing stock price up and making their stock options more valuable.
• He challenged the Fama-French market efficiency theory citing his team’s work that identified 28 important investment bubbles that all “broke completely”. Citing a 2 standard deviation move above the mean, in all cases two-sigma events, were highly predictable and lead to collapses.
• GMO’s research showed that we are getting close to another two-sigma event, as the markets are hovering around 1.5 sigma.
• He said, “There is no chance it will break until we get over Two Sigma.”
• He believes the market will “plod higher” and follow the Fed at least until the election; citing the election as a potential bubble breaking trigger. He added, “I’m going to be incredibly prudent closer to the election.”
• There are no “institutional pessimists,” he said, “and there will be no trigger until individuals pour into the market. We need to wait until deals become more frenzied and individuals become crazy buyers.”
• He does not see a Fed rate hike as the trigger. He forewarned the audience, “you
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