The View from Bannerstone Capital
by Biff Robillard
Chrysemys picta, Wet Gunpowder and Error by Design
“Always remember the future comes one day at a time.” –Dean Acheson
Transition is often tricky. I characterize the current investment environment as one of impending transition, maybe nascent transition. Transition is essential, of course. It’s the stuff between. It connects then to now to next. We can’t get from here to there without it. The evidence for an economic transition is mounting. I seem to see it everywhere I go. Am I imagining it?
Sometimes transition is easy to spot. Like the transition between day and night, seasons, and even generations. Monday evening, Polly and I were taking our jog in the finally transitioned spring weather. As we passed through a stretch of trail that runs close to Lake Minnetonka (yes, Dear Reader, the same stretch that provided the “Dog-Falls-for-Mama-Duck-Ploy” in these pages some years ago), Polly hit the brakes, sniffing cautiously and then pointing at a dark, mostly hidden something at my feet. I had almost stepped on it. Polly puzzled as only a dog does. Then I made it out. Here was a saucer sized, shiny and smooth Chrysemys picta: a painted turtle.
She was sort of in the grass, sort of on the trail, her aft portion awkwardly suspended over a teacup sized hole she had dug, at obviously great effort. Try digging a just-right hole in rock hard ground, behind your back with rubber baby spoons. Tiny mounds of wet sand were evenly piled around the rim. Facing away from the trail, only partially hidden, ignoring the footfalls and bike tires of trail traffic, she was burying treasure: depositing her precious creamy white eggs into the humble earthen vault. Her focus was singular. I have been present at human childbirth and I swear I recognized that innate “I don’t care who you are—I’m having this baby right now” female resolve. More evidence, I suppose, that we really do share a common ancestor with all living things on Earth, including turtles.
Polly’s giant (well, if your head is the size of a Brussels sprout) nose and accompanying maw were acknowledged with slow turtle blinks but otherwise ignored. This gal was meeting her sacred obligation to the most profound transition of all: reproduction, the astonishing transition of life from then to now to next. I realized I had never seen a turtle laying eggs before. And I’m outdoors a lot. We watched, admiring her silent resolve, politely ignored her questionable choice of nest locations and then slipped away, leaving her to her primordial drama. I was rooting the sun lower to help hide her, but fearful that with night would come the raccoons. Go girl.
Allow me to mention a more difficult transition to spot: an economic transition. Here is one of the potentially great opportunities for investors right now. We could be on the cusp of a transition from bad to better, from slow growth and low confidence to accelerating growth and rising confidence. These transitions are rare and invaluable to equity investors. You want to catch them if you can. So stay with me for a second.
It can pay to know how you’re wrong. My dad taught us a neat “error by design” trick for finding a distant unseen island (or lighthouse, or buoy) over the horizon. He knocked around the Keys and Bahamas a lot with only a watch, a compass and a chart (and in the early days, Lucky Strikes). Unlike tall volcanic islands like the Virgin Islands, or Hawaii, our home turf has always been very low relief “keys,” rarely more than a foot above sea level, covered with scrubby mangrove trees. These can be hard to see from any real distance. Rough seas can amplify the problem. Dad taught us to always “shoot” for a spot a mile or more right or left of the distant, unseen target, never right at it. You actually design an error into your trip. Why? Because if after the appropriate passage of time, when you know you are close, you want to know if you need to adjust left or right to get close enough to finally see it. You build a known navigation error into your plan and eliminate half the problem. “I don’t see it, should we turn left or right?” is a baaad feeling far from home. Pop’s lesson: If in doubt, knowing for sure it’s a little more to the right or a little more to the left somewhere helps a lot. This is especially true if the sun is going down. Something tells me he formulated this navigational technique while nervously looking for Bermuda in a SAC KC 97 Stratotanker in the mid 1950’s.
So, how does this metaphor help us as investors? Because right now we currently know which side of the economic target we are on. This is surprisingly rare. We therefore can be pretty sure which way the U.S. economy, over time, will turn next. This helps forecasting stock prices. It is not a 50-50 split like Dad warned us about. We can anticipate the turn we will need to make. This is a real advantage for trend-following growth investors like us. In the midst of an economy running at potential, the next turn is often a coin toss and of little tactical help. Not so now. Our odds are better.
The next turn should be up. Please see Figure 1. Potential GDP (the blue line) has massive inertia in this chart. Real GDP (the red line), not as much. It is Real GDP (red) that wiggles and squiggles around the “mean” of Potential GDP (blue), sometimes hugging it for years at a time. Only in the early 1980s has Real GDP been so obviously below Potential GDP. What happened next was very good for investors then as the Real GDP improved, caught up and eventually exceeded the Potential GDP line (an equally useful caution signal). The Potential GDP line does not falter. Investors currently feel lost, but we really do know which turn is likely the right one. The bias always lies, eventually, in the direction of Potential GDP.
Figure 1 Respect the Relative Inertia: Bet on Real GDP Improving, Not Potential GDP Faltering
Ben Bernanke is thinking about transition and the markets have noticed. I suspect the credit markets are thinking transition, with or without explicit permission from Chairman Bernanke. Any rates other than very short rates are simply higher. This means lower bond prices. The precious metals markets seem to have considered transition first, just as they did in 1980. I find it interesting that gold apparently peaked in August 2011, less than two years ago and about a year and a half before interest rates more recently turned tail—and yes, I am boldly supposing the lows in rates are in.
The gold-then-interest-rate sequence is eerily reminiscent—so far at least—to the early 1980s. The Barbarous Relic peaked at $850 or so per ounce in January, 1980. Twenty months later, on September 25, 1981, the 10-year U.S. Treasury interest rates peaked (along with long-term interest rates in general). Allow me to be the first to point out to you that we may be seeing the very same general sequence here: Gold peaks (August 2011), 21 months later bonds peak (April 2013), then . . . and here’s the fun part—stocks enter a secular bull market for “good”. For those of you scoring the game at home, August of 1982, the Epic Bull of All Bulls, began a scant 11 months after the peak in rates in 1981. Saddle up. Transitions: gold, then bonds, then stocks, then economy.
Jim Grant, of Grant’s Interest Rate Observer, is in my view the greatest investment newsletter writer of all time. Peerless. In a trade swarming with intellectual midgets in poorly tailored clothing, Grant stands utterly alone as the Real Deal, tailored, sincere and smart. I am not vouching for how right or wrong he is. I will leave that to you. I will eternally vouch, however, for how thoughtful and informed he is and as a result, how useful his publication is. (Subscribe if you can afford to: www.grantspub.com) You can never go wrong in this business listening to what smart people are thinking. Agreeing with them is not necessarily the goal.
Anyway, it turns out Jim and I have exactly one thing in common: Sidney Homer’s A History of Interest Rates. Jim occasionally cites the tome in his musings, and it makes me wonder whose copy is more marked up, his or mine. What follows is my own pathetic attempt to do as Jim does, site Homer to support my position. I take some solace knowing Jim does not read The Coteau . . .
QE was a good idea and I can prove it. Almost.
For those of you playing along at home, please turn to page 335 (Chart 34) in the third edition of A History of Interest Rates. Others do the best you can for the next few paragraphs. Your imagination can provide for you. This chart plainly shows nominal long-term bond yields bottomed in 1946. This is surprising to me. Why not 1933? The U.S. economy fell apart in the 1930s, yet Mr. Market did not flatten real bond yields as one would suppose despite deflation, 25 percent unemployment, and a populace scared stiff of the stock market. In real terms, many long-term rates rose in the 1930s. Now flip ahead to page 417, chart 47.
Listen up, QE doubters. For investment quality corporate debt, nominal rates rose sharply in the 1930’s. Adding in the deflation, real rates were even higher than they look. It is true nominal rates on the very highest quality long-term debt fell somewhat during the 1930s but inflation fell too, eventually to negative values: deflation. QE has, I think, been all about preventing a replay of this 1930’s stealth tightening, not “stimulating” the economy via money supply growth (i.e. “printing money”). Whatever money was printed still has not left the reserve accounts of the banks who sold the securities to the FOMC. Ask QE critic Lacey Hunt: there has been almost no growth in the money supply aggregates. Remember, Ben did his homework. That’s how he got to Princeton from Dillon, S.C.
High real long-term interest rates during a depression, of course, are anathema. Corporations do not enter the capital markets; it’s too expensive. Returns on capital cannot support the real cost of the interest on the debt. Investment stops. Corporations hoard cash, fearing they will run out. Investors, traumatized by the Depression and high unemployment, eschew non-guaranteed bonds. Demand for corporate bonds drops, prices for bonds fall, ergo corresponding rates, inverse to price, rise. You can’t give the things away. Individuals hoard cash and ultra-safe securities. Reduced velocity of money starves the emaciated economy further. In this 1930s paradox, a negative-inflation, zero-demand-for-credit world resulted in higher real long-term interest rates, slowing the economy even more. Ben will have none of it. See Figure 2. Behold the bear market in investment grade debt during the Great Depression you never heard about, until now. It isn’t hard to pick out. Ben Bernanke knew this before you did.
Figure 2 Higher Baa rates in the 1930’s: a rational for QE in 2008 and beyond
Slowing economic activity should normally lower real interest rates, providing incentives to rev the engines of prosperity at lower costs. Evidently if fear and deflation achieve a certain critical mass, as they did in the ‘30s, frightening new chain reactions can ensue. The economy doesn’t just cool, it enters a New Pleistocene heading for Snowball Earth. It’s like blinding the pilot by prematurely pulling the rip cord while still in the plane: a solution can become the problem if you lose your cool at a bad time. This is what Mr. Market did in the 1930’s. He crashed the plane.
Knowing this, The Bernank brazenly bought MBS while others pulled ripcords. Ben seems to have understood that the very panic which would, if it had its way, back up rates, would also absolutely prevent any additional bank reserves he was providing from ever seeing the light of day. You see, Ben did his homework. The rest of us were filling cockpits with silk and blaming the pilot, while weeping uncontrollably. The lack of demand for credit was threatening to create higher real rates, at least for corporates and mortgages. Inflation, temporarily, was essentially impossible. This mountain of bank reserves, under these particular conditions, was as dangerous as wet gunpowder in a monsoon. Nobody was going to spend the reserves, at any interest rate—period. So Ben let her rip. We had real rates so low we have had negative real interest rates. Now that’s palliative.
Some observers will forever lament the lack of a true market mechanism to clear prices of credit. In an ideal world, I am with you. Which way to the Ideal World? Recall that the market was very casual about reaching such equilibrium in the 1930s. See Figure 2 again. The low in rates was 1946.Bernanke’s Boost may have shortened this more “natural” timeline by a decade. Yes, a decade. We will never know. If an antibiotic will shorten an infection, will you take it? Or let nature take its course? Ben didn’t put us in the ditch. But I think he could be pulling us out. Please don’t blame the tow truck driver for needing the tow.
It is often said that it was World War Two, not FDR that ended the Great Depression. Conservatives tell this with more gusto than Progressives, generally. I have my own take and it will disappoint both parties. Back to page 335. I believe an eventually restored demand for credit likely ended the Great Depression. This tentative restored demand for credit ended the great bull market in bonds that ran from 1920 until the late 1940s. Nominal rates, after 26 years, finally stopped falling. Years after the Dust Bowl and Great Depression, by the time the second atomic bomb fell, after years of Normandy Beach, Iowa Jima, Treblinka and Auschwitz, the Battle of Britain and Stalingrad, what was left to fear? Maybe everyone was just too exhausted to remain afraid. With fear on the run, demand for credit stirred. It was time for change, a time to bet on a better tomorrow and leave the horrible past behind. It was a transition.
At mid-2013, am sticking with:
- U.S. stocks: up
- Dollar: stronger
- Interest rates: up
- Gold: down
- Commodities: tough on the bulls
- World Series: Boston (Editor’s Note: “No, St. Louis.”)
On a more tentative note, get ready for a transition which eventually, and by this I mean perhaps a year or two from now, could suggest market trouble. Typically a president signals by Labor Day what his (or, ahem, her) intentions are for nominating (or re-nominating) a Federal Reserve Chairman. Ben’s second term is ending next year. I think we suddenly have a pretty good idea Bernanke is stepping down and it isn’t even the Fourth of July yet. Either the die is cast or it was a presidential faux pas. We will likely know by the next Coteau. Although I am surprised and disappointed, it is what it is. I think the economy and markets would do best with the continuity of Dr. Bernanke. Next issue I intend to share the checkered track records for the markets in the early innings of a new and untested chairman. You won’t like it.
Transition is often tricky.
This publication does not constitute investment advice. The views described may have changed by the time you read this, anyway. Use your head, for crying out loud.
Craig Cox is our editor. Thank you, Craig.
Bannerstone Capital Management, LLC is a registered investment advisor. We are on the web at bannerstonecapital.com