Once bullish, contrarian Jim Grant likes cash now

[oec2000]

I am facing exhaustion.  Last 10 years have been something else -- 50% drop in .com collapse, 50% drop in credit crisis.  Will the markets really go down 50% for the third time in 15 years?  Aside from including the Depression, there has been no other period like it in the past 100. 

 

It's like people are always talking about the next collapse around the corner, and then there is one!

 

Why does this have to keep happening to us?  At this pace there just may be 20 yr olds in the coming years ahead who will be able to say the market was higher back when they were born.

 

 

There are lots of 20-year old Japanese who can say that markets were 300% higher when they born vs. current levels.

 

There has probably not been a period in the US in the past century when there was such a combination fiscal and monetary irresponsibility so it may not be useful to rely solely on past US experience to handicap what is likely to happen.

[stahleyp]

About the only one I can think of that is Bullish is Buffett. I wonder if he's looking more out over a 20 years period.

 

Quoting from the 2010 annual letter:

 

In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.

 

A housing recovery will probably begin within a year or so.

 

Watsa also thinks his stocks like JNJ, WFC will increase significantly in value over the coming years (it says so right there in the annual reports).  He is just pessimistic about the market as a whole.

 

I wonder how bullish he really is. I think he sees himself as a spokesperson for capitalism and also has to show confidence in the country. Maybe I'm wrong, but he's accomplished so much that he's trying to be a good steward of faith in America, too.

 

I'm sure most of you guys have read this, but here it is again.

 

http://www.berkshirehathaway.com/letters/growing.pdf

 

This sounds like he's not too hopeful...and I don't think things have gotten any better.

 

 

[ERICOPOLY]

There are lots of 20-year old Japanese who can say that markets were 300% higher when they born vs. current levels.

 

I want to hear what actually happened to Japanese earnings during this period, vs what the stock market did.  How did a focus on Japanese listed stocks perform where no more than 25% of sales were on the Japanese mainland -- would that have done far better than a focus on stocks where 100% of sales were on the mainland?

 

Did one suffer 75% losses over the past 20 years if one had bought multinationals with P/E of 7-12 and only 25% of sales in Japan?  That was rhetorical, we know the answer to that one.

 

The Japanese stock market in 1989, I've read, was at a P/E of 65x, and (I'm guessing) the businesses heavily reliant on sales within Japan have suffered the most.  

 

Starting at a high P/E of 65x is hard -- it was going to fall 75% due to mean reversion alone, and that kind of decline brings the market down to a P/E of 16.25x.  From there profitability likely fell apart, explaining why it's absorbed 20 years of earnings.

 

Anyhow, to compare Japan to the US market today, we're already at that collapsed level of P/E in the teens -- the risks now would be the collapse in earnings and, can you avoid it by sticking to the multinationals?

 

[stahleyp]

Eric,

 

I'm glad you post here. I really like your contributions. I can't say I really ever thought about the Japanese market quite like the way you're looking at it. Thanks for opening my eyes a bit on that one!

[oec2000]

There are lots of 20-year old Japanese who can say that markets were 300% higher when they born vs. current levels.

 

The Japanese stock market in 1989, I've read, was at a P/E of 65x, and (I'm guessing) the businesses heavily reliant on sales within Japan have suffered the most.  

 

Starting at a high P/E of 65x is hard -- it was going to fall 75% due to mean reversion alone, and that kind of decline brings the market down to a P/E of 16.25x.  From there profitability likely fell apart, explaining why it's absorbed 20 years of earnings.

 

Anyhow, to compare Japan to the US market today, we're already at that collapsed level of P/E in the teens -- the risks now would be the collapse in earnings and, can you avoid it by sticking to the multinationals?

 

 

Even if the Japanese market had started at 16x PE in 1989 (i.e at 10,000 instead of 40,000), the market today would still be only about the same level as it was >20 years ago. In 2000, the US markets peaked at 30x (?) PE. It is not implausible that the market could be lower than that peak after 20 years. I'm not saying it will happen but it is a risk I would not rule out yet.

 

Even the US market went nowhere between the mid-1960s and 1980 and I do not think the starting valuations were as high as they were in 2000.

 

I agree that value investors can beat the markets over such periods and do well - but your original point was about markets in general. There are two plausible potential reversions to the mean that would adversely affect markets - lower corporate profit margins and higher real interest rates - so we are not talking about exceptional stuff here. (In Japan, we haven't even seen interest rates revert to the mean yet.)

 

Given their dismal track record, I am not betting on the politicians or the Fed engineering a happy ending to our economic problems. America will eventually get it right - but chances are it will take a crisis to force the policy makers to find real long term solutions.

[ERICOPOLY]

There are lots of 20-year old Japanese who can say that markets were 300% higher when they born vs. current levels.

 

The Japanese stock market in 1989, I've read, was at a P/E of 65x, and (I'm guessing) the businesses heavily reliant on sales within Japan have suffered the most.  

 

Starting at a high P/E of 65x is hard -- it was going to fall 75% due to mean reversion alone, and that kind of decline brings the market down to a P/E of 16.25x.  From there profitability likely fell apart, explaining why it's absorbed 20 years of earnings.

 

Anyhow, to compare Japan to the US market today, we're already at that collapsed level of P/E in the teens -- the risks now would be the collapse in earnings and, can you avoid it by sticking to the multinationals?

 

 

Even if the Japanese market had started at 16x PE in 1989 (i.e at 10,000 instead of 40,000), the market today would still be only about the same level as it was >20 years ago.

 

 

I agree.  I pointed out that the market (adjusted for valuation premium) being flat for 20 years in Japan must have been due to collapse in earnings.  Unless the Nikkei market index doesn't include paid dividends, but I'm assuming it does include them.

 

In 2000, the US markets peaked at 30x (?) PE. It is not implausible that the market could be lower than that peak after 20 years. I'm not saying it will happen but it is a risk I would not rule out yet.

 

I'm not ruling it out either, but I wonder if our market with over 40% of it's revenues in international markets is as vulnerable as Japan's.  Is our index better diversified by geography?  I have no idea -- for some reason the guru's don't care enough to find out either (I've never heard them mention it).  I've spent a lot of time on Google/Bing trying to find any mention of it, hopefully somebody else can do better.  

 

 

Even the US market went nowhere between the mid-1960s and 1980 and I do not think the starting valuations were as high as they were in 2000.

 

Right, you are being more fair by picking a better entry valuation (however still historically quite high), but you've cherry picked a terminal point with a historically low terminal valuation.  And in the 1965 the market P/E was about 23.  So between 1965 and 1980, the market premium on earnings declined by nearly 2/3 -- not quite as big as the Nikkei valuation adjustment, but impressive nonetheless.  I think if you had picked 1966 and 1982 as the terminal points you might see a Nikkei sized premium adjustment.

 

 

[jb85]

It would be interesting to see what the margins were like during the japan bubble, and if those margins are now lower than the mean (over past century).  It seems to me if you are going to compare US and Japan, you have to compare P/E AND profit margin. 

 

Is the problem that Japan had a P/E of 70 AND the margins were abnormally high (in effect giving a P/E ratio much higher than 70-when using normalized earnings).

 

 

Furthermore, is the Japan P/E of 16 really overstated because of below normal margins?  I'm not sure on any of these, but as I understand it, this is how grantham arrives at his fair value market (and what the shiller 10 year P/E does in practice as well).

 

[oec2000]

Even if the Japanese market had started at 16x PE in 1989 (i.e at 10,000 instead of 40,000), the market today would still be only about the same level as it was >20 years ago.

 

I agree.  I pointed out that the market (adjusted for valuation premium) being flat for 20 years in Japan must have been due to collapse in earnings.  Unless the Nikkei market index doesn't include paid dividends, but I'm assuming it does include them.

In 2000, the US markets peaked at 30x (?) PE. It is not implausible that the market could be lower than that peak after 20 years. I'm not saying it will happen but it is a risk I would not rule out yet.

 

I'm not ruling it out either, but I wonder if our market with over 40% of it's revenues in international markets is as vulnerable as Japan's.  Is our index better diversified by geography?  I have no idea -- for some reason the guru's don't care enough to find out either (I've never heard them mention it).  I've spent a lot of time on Google/Bing trying to find any mention of it, hopefully somebody else can do better. 

Even the US market went nowhere between the mid-1960s and 1980 and I do not think the starting valuations were as high as they were in 2000.

 

Right, you are being more fair by picking a better entry valuation (however still historically quite high), but you've cherry picked a terminal point with a historically low terminal valuation.  And in the 1965 the market P/E was about 23.  So between 1965 and 1980, the market premium on earnings declined by nearly 2/3 -- not quite as big as the Nikkei valuation adjustment, but impressive nonetheless.  I think if you had picked 1966 and 1982 as the terminal points you might see a Nikkei sized premium adjustment.

 

Unless I'm mistaken, neither the Nikkei nor the S&P indices include paid dividends. There are total return indices that account for dividends but the widely quoted indices do not. In any case, dividend yields in Japan have historically been very low.

 

Although I have no idea what the figures are, I would intuitively expect foreign revenues to be quite high for Japanese companies given their highly export-oriented economy. Again, it is hard to say without looking into the hard numbers but Japanese company earnings would have been hit much harder if they had not had the benefit of the US consumer over the past couple of decades.

 

Japan also had a few things going for them that the US currently does not have. Low inflation and interest rates (1+% 10 year bond yields), a booming global economy that was awash with liquidity, and strong current account surpluses. The US today is much more vulnerable to economic shock. Whether you think the current economic troubles will end in higher inflation and interest rates or deflation and lower rates, neither outcome seems particularly favourable for stock valuations. I don't see how the current muddle through policies of high deficits and low interest rates can sustain moderate growth with moderate inflation without an eventual day of reckoning.

 

I accept that 1980 is a cherry-picked endpoint but is it an unfair comparison given our current situation vs. that in the seventies? I don't think it is a stretch to make the case that the economic fundamentals today are at least as bad as they were in the late seventies.

[ERICOPOLY]

 

Furthermore, is the Japan P/E of 16 really overstated because of below normal margins?  I'm not sure on any of these, but as I understand it, this is how grantham arrives at his fair value market (and what the shiller 10 year P/E does in practice as well).

 

 

I was watching the David Herro interview on Wealthtrack a few minutes ago.  He says that before the recent earthquake in Japan, their market was trading below book value and at 8x cash flow.

 

Regarding below normal profit margins:

According to what I can find, Japan's market might trade at 1/2 that of the US right now, on a price/sales basis (at least based on their relatively few example provided in this article):

 

http://news.businessweek.com/article.asp?documentKey=1376-LIA1DS1A74E901-4LRJN3S7NRVB4U9LDB6AQ1SBJ5

 

 

[ERICOPOLY]

I accept that 1980 is a cherry-picked endpoint but is it an unfair comparison given our current situation vs. that in the seventies? I don't think it is a stretch to make the case that the economic fundamentals today are at least as bad as they were in the late seventies.

 

The rate of inflation is much lower (all we really care about are real returns).  I believe the low P/E in early 1980s was a result of not only high inflation, but the risk-free alternative yield being very, very high made stocks look less attractive until earnings yields went up as P/E compressed.

 

I guess what I'm saying is the comparison is not a good one to today.  Except it's a reminder that should we get high inflation and high interest rates, then the market can go down 1/2, even without a hit to profitability.  Although, I'm already at 7x P/E in some of my holdings, so a large comfort margin and much cheaper than 1980 in terms of real earnings yield.

[ERICOPOLY]

Although I have no idea what the figures are, I would intuitively expect foreign revenues to be quite high for Japanese companies given their highly export-oriented economy. Again, it is hard to say without looking into the hard numbers but Japanese company earnings would have been hit much harder if they had not had the benefit of the US consumer over the past couple of decades.

 

I found a site with some Japan trivia -- however I can't say if their data is accurate.

 

First thing I notice is that their population only gained 4% during the entire 22 years since 1989!  Talk about a lack of a tailwind in consumer demand.  Does the US have this problem?

 

http://www.tradingeconomics.com/japan/population

 

Their exports have doubled since 1989.  

 

http://www.tradingeconomics.com/japan/exports

 

Their unemployment rate since 1989 peaked at 5.5% and has since come down to 4.5%.  It's about double today from where it started out at around 2.3%.

 

http://www.tradingeconomics.com/japan/unemployment-rate

 

Why is it that it takes them about 8 years after their crash before their unemployment rate rises even 100 bps?  Does it take 3 workers to screw in a lightbulb, and do they never get fired when profitability suffers?  Any cultural difference here in the US with regards to cutting staff in the face of slackened demand?

 

GDP per capita has doubled (purchasing power parity):

 

http://www.tradingeconomics.com/japan/gdp-per-capita-ppp

 

GDP growth rate adjusted for inflation:

 

http://www.tradingeconomics.com/japan/gdp-growth

 

GDP per capita constant prices gained roughly 27%:

 

http://www.tradingeconomics.com/japan/gdp-per-capita

 

This data here shows a very small amount of deflation -- prior to 2009 it had always been less than 1% annualized, normally barely above 0%.  It leaves me to wonder if their prices would have held up better with US population growth rates -- with an extra 20% more people due to population growth, any impact on consumer prices?  Would production have needed to expand more to meet the rising consumer needs?  US population has grown about 25% vs Japan's 4%.

 

http://www.rateinflation.com/inflation-rate/japan-historical-inflation-rate.php?form=jpnir

 

 

I found a US GDP per capita PPP data source, and it looks like from 2000 through 2009 the US and Japan growth rates are the same:

http://www.tradingeconomics.com/japan/gdp-per-capita-ppp

 

 

 

[oddballstocks]

Check out this thread, a number of people crunched the numbers on the macro picture there: http://www.bogleheads.org/forum/viewtopic.php?t=23036

[vinod1]

 

Their unemployment rate since 1989 peaked at 5.5% and has since come down to 4.5%.  It's about double today from where it started out at around 2.3%.

 

http://www.tradingeconomics.com/japan/unemployment-rate

 

Why is it that it takes them about 8 years after their crash before their unemployment rate rises even 100 bps?  Does it take 3 workers to screw in a lightbulb, and do they never get fired when profitability suffers?  Any cultural difference here in the US with regards to cutting staff in the face of slackened demand?

 

 

From what I read, Japanese managers would go to great lengths to avoid layoffs. Once read a story of how a manager committed suicide and left the insurance or some money that he would get upon his death for his workers. So I think this is mostly cultural.

 

You might find some charts on the data you are looking for by googling "The First Cuckoo of Spring? Is Japan A Buy?". It has profit margins, ROE, div yield charts going back 30 odd years.

 

 

Vinod

[oec2000]

First thing I notice is that their population only gained 4% during the entire 22 years since 1989!  Talk about a lack of a tailwind in consumer demand.  Does the US have this problem?

 

No, but the US has many headwinds that Japan didn't have in 1990 - overleveraged consumer with impaired credit histories; states and municipalities in fiscal distress; commodity price inflation squeezing disposable incomes; higher taxes on the horizon.

 

Why is it that it takes them about 8 years after their crash before their unemployment rate rises even 100 bps?  Does it take 3 workers to screw in a lightbulb, and do they never get fired when profitability suffers?  Any cultural difference here in the US with regards to cutting staff in the face of slackened demand?

 

This has long been a criticism of the Japanese system. There is a huge cultural difference with the US - Japanese managements do not have the same focus on profitability as in the US which explains the low ROEs historically in Japan. Sony is a good example of a company with a premium brand in the 1990s that was not able to translate this moat into superior returns for shareholders.

 

This data here shows a very small amount of deflation -- prior to 2009 it had always been less than 1% annualized, normally barely above 0%.  It leaves me to wonder if their prices would have held up better with US population growth rates -- with an extra 20% more people due to population growth, any impact on consumer prices?  Would production have needed to expand more to meet the rising consumer needs?  US population has grown about 25% vs Japan's 4%.

 

Interesting - the numbers don't jive with the numbers I thought FFH mentioned (in the AR?) that prices deflated by about 15% in Japan. Wonder if FFH are looking at a different indicator?

 

Anyway, we shouldn't expect the Japanese experience to replay itself identically in the US - there are too many differences. It is more important to identify the headwinds and tailwinds that the US will have going forward. If we just compare the US now to the end of 2007, I don't believe market valuations are materially different (other than in quality large caps); yet, the economic fundamentals are decidedly weaker.

[stahleyp]

The way I see it, right or wrong, is that there are a bunch of really great investors who are bearish along with Grant. I suppose one could make the argument that they are bearish because of Grant, too.

 

Klarman -

 

http://www.senseoncents.com/wp-content/uploads/2010/09/Seth-Klarmanm-Interview-Financial-Analyst-Journal.pdf

 

Romick from FPA -

 

 

http://www.fpafunds.com/news_05052011_valueinvesting.pdf

 

Watsa -

 

http://www.gurufocus.com/news/105553/prem-watsas-fairfax-financial-bets-174-million-on-deflation

 

Einhorn -

 

http://www.nytimes.com/2010/05/27/opinion/27einhorn.html?pagewanted=all

 

About the only one I can think of that is Bullish is Buffett. I wonder if he's looking more out over a 20 years period. Though he was wrong about the subprime crisis.

 

http://www.marketwatch.com/story/buffett-says-subprime-crisis-not-a-big-threat-to-us-economy

 

 

This is just a reminder about how far Buffett is versus everyone else. Looking back at these old threads is a good way to keep perspective.

[Cigarbutt]

This is just a reminder about how far Buffett is versus everyone else. Looking back at these old threads is a good way to keep perspective.

Thank you for the reminder.

So what's the message?

Probably best to invest in the Market like a private business owner would.

 

Interesting because I'm re-reading Money of the Mind by James Grant, written in 1994, at a time when he described the long term trends that gave rise to the democratization of credit in conjunction with the socialization of risk...

Mr. Grant has a tendency to stick his neck out. He can be dead wrong, can be right too early or when it does not matter but I find that what he writes is always interesting and thought-provoking. A quote that resonates (given my training background) is: " In science, progress is cumulative, and in finance, progress is cyclical."

 

Indeed, Mr. Buffett stands out. He has always been able to combine exposure and protection from tail risks, and to ride the cycles as the Market has a life of its own.