Gavyn Davies ‘fails’ the CFA test

In FT, Gavyn Davies has a piece in which he makes the case for equities for the long-term, from here on. He has a chart on the current after-tax profit as a % of GDP in the US. It is at the highest. Now, he considers the argument made by James Montier about the mean-reversion in profit margins and dismisses it in the light of the so-called age of globalisation of labour (or, factors of production, more broadly?), despite the fact that mean-reversion in margins is very strong. First, it is arguable that globalisation has more to go. It is probably slightly past its peak now.

Second, that was not the only point that James Montier made in his note. I think he also wrote – and correctly – that the reason why we have a strong private sector in the US is now precisely because the government has chosen to bail it out. Huge government debt and deficit and private sector cash mountain are two sides of the same coin.

So, two questions arise : (1) What happens when the government has to start to tighten the belt, say in 2013? Will a recession ensue then, if it has not already started in 2012? (2) What are the distributional consequences of government largesse for the private sector? After all, profit margins are high because the nominal wage growth for non-supervisory workers is 1.6% – well below the rate of inflation. Does it really augur well for healthy and sustainable demand growth in the US?

Two more points about the misleading comparison of equity returns vs. bond yields. One nuanced point is made by John Hussman:

Among the problems with these typical approaches is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.

The larger difficulty is the estimate of the prospective return on stocks. If you want to use a 10-year Treasury yield as a benchmark, you would also want to use a 10-year projected return for the S&P 500. On that note, and using reliable valuation methods (see above), the difference between the expected 10-year total return on stocks and the 10-year Treasury yield is presently less than 2% (nominal). [Link to his full Weekly Market Comment of 26th March 2012]

Of course, ‘see above’ is possible in this blog since he is referring to his weekly comment (link provided above). There, he shares with us information on the model that forecasts S&P 500 stock returns at 4% per annum, going forward. [GMO in his monthly asset-class return forecasts projects a mean return of just 0.5% (+/-6.5%) per annum over the next 7 years for US large-cap stocks].

We will make a less subtle point too. The earnings yield on S&P 500 stocks is 7.7% according to Mr. Gavyn Davies. Perhaps, he divided up the full year 2011 earnings with the average or closing value of S&P 500 market capitalisation for 2011. He compares it with the 10-year Treasury bond yield of around 2.2% per annum.

We have taken note of John Hussman’s objection above. Both are not assets of same duration. Both are not assets of same risk. Stocks should yield more. But, is it yielding 5.5% more. Again, as John Hussman notes, 2.2% is the prospective yield on the 10-Year T-Note. 7.7% is the realised earnings yield. Converting the P/E ratio into a prospective earnings growth of 7% does not wash.

The question I have is whether the record earnings yield has anything to do with the fact that the government has suppressed the bond yield?

Frankly, had a student of CFA given the answer that Mr. Davies has given as to why equities should do well going forward, he might not have received a good grade for that answer.

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Quick reading links

Transiting in Dubai on way to Kuwait. The news-report in New York Times on how America is inching towards self-sufficiency in oil is well written and worth a read. I have used that as one of the pillars for my MINT column coming up on Tuesday.

March continues to set records as December, January and February did in the US, for temperatures. See reports here and here.

The research outfit, Macroeconomic Advisors, run by the former Vice-Chairman of the Federal Reserve estimates that around 72, 000 jobs were due to the good weather in February.

It might be worthwhile picking up Shirakawa’s speech in Washington, D.C. His remarks are well made. Briefly covered here in Bloomberg.

We should also duly take note of what Jon Corzine did with customer accounts at MF Global.

Either the Federal Reserve Chairman or the Bloomberg reporter or both might be failed (‘F’ Grade) for this.

Boom time in India

It is not a drizzle. It is not a downpour. It is a torrent. It is a tsunami. India’s politicians and bureaucrats are at it. Even those with an explicit agenda to undermine and destroy the nation won’t be doing it this well. In these days of tight budgets, countries could save money on undermining India’s defences, militarily and otherwise. India can do it by itself and much better.

That is the message of the ‘Open letter’ from the Finance Minister of Philippines to the Finance Minister of India written by Jerry Rao. IT is about how India’s taxmen are driving IT businesses to the Philippines. It takes IT (Income – Tax) to destroy IT (Information Technology). IT is getting its revenge on IT because it has been outside the tax net and that is one of the reasons why it boomed. Now, that is on the chopping block in the IT department.

The Comptroller and Auditor-General (CAG) once again estimated that the Government of India ‘lost’ 210 billion dollars in the allocation of coal mines. The CAG numbers were outrageous. Even if there was an allocation of mines at less than the fair value of the discounted cash flows from the coal to be mined out from the mines, it can be a conscious decision. Suppose, the mines were indeed auctioned to the highest bidder. That company’s cost of power generation would be so high and the recovery from user charges in India is so low that the company would soon go bankrupt and the State would have to step in, ask banks to defer loan repayment, etc.

If nothing is done, we simply would have a sick company sitting on production rights and not doing  anything. It would simply be waiting for some one to buy out the license and close shop. The lost production, wasted man and woman hours, etc., – how can the CAG account for it?

At one level, what can be argued is that these are examples of the distortions that our contorted subsidy and fiscal policies cause. That  is fair. But, the precise number is vastly exaggerated as Surjit Bhalla argues with more numbers. I have not gone into them.

All public policy decisions, including honest decisions, involve trade-offs. The CAG has said that the loss figures, purportedly estimated by it, were exaggerated and not the final loss estimate. Nonetheless, it got Surjit Bhalla enraged just as Mr. Mukherjee’s retrospective tax law amendments did, last week.

Shekhar Gupta documents the massive deterioration in Centre -State relations and recalls fondly how in Vajpayee’s times, things were better between Delhi and West Bengal:

On counter-terror measures, for example, there was closer understanding — and trust — between the Left-run West Bengal and BJP’s New Delhi when you could not find two political formations further apart ideologically. In fact, it was much, much better than the relationship between the current UPA and its own ally Mamata Banerjee’s government in Kolkata. That is because A.B. Vajpayee reached out to other parties’ chief ministers with respect and warmth, and earned some of that in return as well. Today’s breakdown is genuinely widespread, and has spread to individual, almost personal hostility and distrust for many ministers in the Central cabinet.

I lost a night’s sleep after I read how Mukul Roy, the new Railway Minister at the Government of India, not only rolled back most of the fare increases announced by his predecessor (asked to resign by Ms. Mamata Banerjee for daring to do so) but also even put the appointment of a Committee to examine the formation of an independent rail tariff authority on hold.

A Tamil daily reports that milk and electricity fares have been raised by the Mamata Banerjee government in West Bengal. That is not wrong. That is an economic necessity, thanks to three decades of misrule by the Marxists. But, why is she so dismissive of the plight of an important and prestigious institution like Indian Railways? The casualness with which some of these things are done is truly alarming. It should be noted here that the Lok Sabha (lower house of Parliament) passed Mr. Roy’ motion to roll back without any protest. Did any one stand up and argue against it?

Can intellectuals afford to leave here politicians and bureaucrats behind? Jayati Ghosh and C.P. Chandrasekhar provide an intellectual fudge to what they call ‘the subsidy hoax’. They argue that the government earns more in taxes than what it doles out as subsidies on oil products. Therefore, the current subsidy regime has to continue and that there is no need to raise prices. The Op.-Ed. makes several flawed assumptions and makes misleading arguments. It needs to be discussed separately.

T. N. Ninan dares politicians to come up with concrete numbers for defining the poverty line. Will they do it? We should note here that the BJP too questions the Planning Commission’s poverty line definition. Intellectual irresponsibility is now not the sole prerogative of the Left-Liberal flank in India.

‘Economist’ takes note of India’s lost magic and writes a fairly muted (surprisingly) Leader article on it. One important point that they make is that while 6% growth rate is nothing to be sneezed at, it might not be enough to ensure fiscal stability for the country where subsidies are still rising faster than nominal GDP. A slightly longer essay on India puts the challenges and opportunities in perspective.

Ayn Rynd would be happy with her disciples in Indian politics. They have adopted her message of self-interest, faithfully implemented it and have become prosperous in the process. To hell with national consequences.

It is  boom time for subversion of India.

Any tear left to shed?

More than a year ago, I wrote a piece in MINT asking the readers to save their tears for India. Then, I wrote a blog post on April 30th in 2011 that the tear ducts were exhausted. Hope there is something left in the ducts. Another opportunity has arisen to shed more tears now. It is not that the Railways would sink tomorrow or that it might be a bad thing if it did or that the poor passengers should not be spared. There are many other ways of providing relief to the poor. Many of us have cried ourselves hoarse on subsidising the poor. It is not that there is no case for doing so. It is about how much, how, for how long and for whom. It is about pandering to the present generation versus remembering one’s obligation to future generations of Indians. Why is India cursed with its politicians? In May 2011, I wrote that it was difficult to redeem the UPA government. It has gone way beyond redemption now.

Reality check in page 5

“I am an investment strategist focused on emerging markets. You learn to be humble. A while back a firm put out this very good report, and on page five they wrote: ‘Whoever rips this page out and sends it to us gets £50.’ I believe they ended up paying out only £250. Apparently few of their other clients had gotten as far as page 5 of the report as investors are deluged with information daily. [More here]

Good reminder and cross-check on one’s importance (or, the lack of it) in the overall scheme of things. This is from the ‘Voices of Finance’ series in Guardian. A friend had sent another link in this series that led me to the ‘Voices of Finance’ page. You might want to check out this too.

Fiscal deficit irrelevance

Authors Devina Mehra and Shankar Sharma have written a rather disappointing piece on India’s fiscal deficits. Surely, it is not ignorance of economics that has led to the arguments that they make. Here are some counter-arguments:

(1) Fiscal deficits are, per se, not bad. They may be good, if moderate, and if they boost potential growth or the non-inflationary growth rate of the nation. UPA fiscal deficits fail on both counts. The Reserve Bank of India now estimates that India’s potential growth rate to be 7% rather than 8% or higher. Surely, that one argument alone is sufficient to discredit the fiscal deficit record of the UPA regime.

(2) It is mischievous to suggest that the debt-to-GDP ratio worsened under the NDA administration and has improved under UPA. UPA enjoyed the benefits of global growth boom and the lagged effects of infrastructure spending and other reforms undertaken during the NDA regime. For economists failing to take into account and acknowledge lag effects is a serious omission.

(3) Rural consumption growth is good provided it is sustainable. Second, it need not and should not come at the expense of creating rural assets. Yes, China might have over-invested but the answer to that is not that India should over-consume. There is a golden mean to both. The alternative for India’s consumption-investment imbalance is not China’s investment-consumption imbalance. The authors deliberately set up a strawman to knock it down.

(4) Subsidies are good provided they fulfill the stated objectives that they are intended for. A near 50% leakage and wastage of food under the Public Distribution System is no one’s definition of welfare or growth-enhancing subsidy. How much of subsidised diesel goes to power pumpsets and how much of it powers four-wheel drive vehicles on Indian city roads? Even if all of them go to power pumpsets, is it good? What happens to water tables and excessive water logging in Indian paddy fields?

(5) Part of the deficit growth under the UPA regime has occurred due to the farm loan waivers granted some months before the 2009 elections. Recently, the Chairman of the State Bank of India stated in a conference hosted by this newspaper that it has damaged attitudes towards loan repayments among farmers. Non-performing agricultural loans are rising and that is because farmers expect another loan waiver. Does that augur well for flow of credit to the sector, its future production and national economic growth prospects? We have blogged on it here.

(6) The National Employment Guarantee Programme that does not create assets has led to widespread labour shortages and destroyed work ethics. Many studies – some done by this newspaper – have documented that. Anecdotal evidence from entrepreneur-friends reinforces evidence from macro surveys.

(7)  If the economic growth rate under the NDA regime was low and there were some significant negative growth shocks during that period – 9/11 impact, US recession, global slowdown, technology sector slump, drought in 2002, sanctions for the 1998 nuclear test by India and launch of the war on Iraq by the US and its allies – then it makes the case for deficit spending to pick up the slack.

In contrast, economic growth under UPA regime since 2004 was good.  [Pl. note that it is incorrect to credit the government for that. It happened due to the lagged effects of reforms and infrastructure spending under the NDA regime and solid global growth during that period]. In periods of good economic growth, there is no need to augment it further with fiscal deficits. That is wasted stimulus. Far from patting the UPA for its so-called record on government debt, the authors should have pulled the government up for its lack of seriousness in using good times to save for the rainy day. Adding to domestic demand when not necessary is to keep the doors open for higher inflation.

(8) Surely, the authors do not think that the Reserve Bank of India is ignorantly pushing the line that the government’s fiscal profligacy has added to inflation pressures and complicated their monetary policy management? Perhaps, they have not had the time to read Dr. Subbarao’s seminal speech on the monetary policy trilemma. The Reserve Bank of India has had to monetise the government borrowing and thus be an unwilling accessory to the government in stoking India’s inflation pressures.

(9) It is a fact that the government deficit and the consequent borrowing have crowded out the private sector. They have resorted to foreign currency borrowings. Their questionable accounting practices (permitted by relevant authorities, of course) created a temporary spike in demand for US dollars, sent the rupee plummeting and have raised India’s import costs. The government’s fiscal deficit has had a role in rupee weakness thus, not to mention its contribution to the perception of India’s mounting macro-economic risks.

(10) Government of India’s fiscal deficit contributed directly and indirectly (by stoking aggregate demand) to India’s current account deficit. One can argue that 3.6% current account deficit – GDP ratio is not a high external deficit ratio. What is high or low is actually a function of how much of it is the market willing to finance. Clearly, India looks vulnerable now on the external funding angle.

(11) With all their acts of omission and commission, the two UPA governments have damaged India’s macro and micro-economy. Consequently, India faces the prospect of lower economic growth rate in the years ahead. Then, if the UPA were to be voted out of office in 2014, India’s lower economic growth rate might coincide with another non-UPA administration at the office. Voila! That would prove the authors’ point that UPA’s deficits have been good for India!

Reaction to reflections on gold

Our thoughts on Mr. Buffett’s thoughts on gold

In the website of Berkshire Hathaway, the latest letter by Mr. Buffett to his shareholders is to be found. Here is the link.  More specifically, the link to his letter for the year 2011 is here.

If one does a search for ‘Gold’ in this letter, one gets 16 hits. Page 18 contains his famous illustration on how the gold pile could be converted into something more valuable like crops, etc. In case someone is too lazy to search, here are the relevant portions:

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.)

At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.

Unfortunately, there are many intellectual flaws in this reasoning.

(1) Everyone knows that gold has no intrinsic value because it is an asset that produces no cashflows. Therefore, most of us know that it is bought when there is ‘fear’ of something. When we fear something (inflation, war, worthless paper money), we try to protect ourselves against ‘that’. That is, we buy insurance. Investors therefore have to treat gold as insurance and most do so. It is simply wrong to compare an insurance contract to investment assets. That is why it is wrong to put all savings into gold, unless one is driven by extreme fear. If we get rid of all assets, there is no need for insurance.

The only decision on an insurance contract is whether the premium being charged is too high, compared to other alternatives. Second, whether the premium is high or low depends on the value of the assets that are being insured. It is not based on the absolute amount of premium payable.

(2) Regardless of the societal utility of farmland, for an investor to buy farmland today, she has to take into account the question of whether the price of that land today already discounts the utility/cashflows that she would derive from that in the years ahead. In other words, the same ‘bubble’ analysis that Mr. Buffett subjects gold to (and wrongly, in our view, because it is not an investment asset) should be applied to the so-called farm assets that he extols.

(3) Gold has no nationality. Crop lands are located within national borders. Not all can buy land everywhere in the world. Land prices are not cheap in many parts of the world, actually. Perhaps, they are cheap in some parts of the US. Further, crop lands are lumpy assets and cannot be easily converted into cash, when needed. Gold can be bought in small quantities and is easily sold.

(4) We all know that gold prices crashed and remained in a state of coma from 1982 until 2000. We also know that they stirred and roared from then on. As investors, we simply have to ask ourselves the reasons for Gold’s staggering underperformance in the 1980s and 1990s and its staggering rise in the first decade of the New Millennium.

In the last two decades of the last millennium, commodity prices were slumping. Technological developments raised productivity. Measured inflation rates were low in the US and in most of the developed world. There was peace dividend with the collapse of the Berlin Wall and the disintegration of the Soviet Union. The United States ran fiscal surpluses in the second half of the 1990s and the dollar was strong for at least ten out of those eighteen years. The perception of the United States as the world’s unquestioned political, military and economic power was quite high. Therefore, no one questioned the strength of the US dollar. The Federal Reserve, under Mr. Volcker first and then Greenspan later, enjoyed high credibility. It is a different matter that history would judge Greenspan harshly.

To conclude, we reiterate that gold is an insurance asset. If its price already reflects the risks of inflation and fiat money (paper currency) debasement and that these risks would only be receding from here on, investors could sell gold.

Put differently, there is no need for insurance if we judge that there is no risk to protect against. That would dictate whether we retain gold, buy gold or sell gold. That is a matter of judgement.

Yours truly is happy to retain and buy.