← Hidden Forces
Hidden Forces
The Last Bubble? Finding Value in a World on Fire | Jeremy Grantham & Edward Chancellor
00:49:24
Loading summary
Transcript53 lines
- [00:01]
A
What's up everybody? My name is Demetri Kofinas and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guests in this episode of Hidden Forces are co founder and chief investment strategist of asset management firm GMO Jeremy Grantham and financial historian, journalist and investment strategist Edward Chancellor. Together they have collaborated on Jeremy's autobiography titled the Making of a Perma Bear, which chronicles Grantham's evolution as a value investor and the valuable lessons that can be learned from his six decade career in investment management. We spend the first hour of our conversation discussing the collaboration behind the book, Jeremy's formative experiences in finance, the principles that have guided his investment philosophy, the role of mean reversion in asset markets, and why they both believe that US equities are more overvalued today than than at almost any point in history, with critically important implications for where returns will come from over the next decade. The second hour is devoted to a conversation about the mechanics of financial bubbles, the relationship between ultra low interest rates and asset price inflation, Jeremy's framework for navigating overvalued markets by shifting capital to international and emerging market equities, the challenges of selecting investment managers who and Jeremy's deep concerns about existential risks to humanity, including climate change, resource scarcity and the toxic assault on human fertility that he believes poses an underappreciated threat to our species long term survival. If you want access to all of this conversation, go to HiddenForces IO, subscribe and join our Premium feed, which you can listen to on your mobile device using your favorite podcast app just like you're listening to this episode right now. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, which includes Q and A calls with guests, discounted access to third party research and analysis, and in person events like our intimate dinners and weekend retreats. You can also do that on our subscriber page. If you still have questions, feel free to send an email to infoiddenforces IO and I or someone from our team will get right back to you. Lastly, because this conversation deals with investing nothing, nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis for financial decisions. And with that, please enjoy this incredibly thoughtful and valuable conversation with two of the most brilliant and Seasoned minds in finance. Jeremy Grantham and Edward Chancellor. Jeremy Grantham and Edward Chancellor. Welcome to Hidden Forces.
- [03:03]
B
Nice to see you, Demetri.
- [03:04]
C
Hi.
- [03:06]
A
So you both collaborated in the writing of Jeremy's biography or autobiography. What was the nature of that collaboration? How did it begin? And Jeremy, more to the point, what led you to want to write this book and to tell your life story to begin with?
- [03:22]
C
I'm a lazy bum and I pretty well knew I'd never get the book written, even though I was full of grandiose plans for at least half a dozen in my life. And I knew Edward was a real professional. He wrote to deadlines and he'd written a couple of excellent books. So if we wanted to get a book written, he was a natural candidate to write hurt on me and keep me under control. All of which he did.
- [03:55]
A
What was it in Edward's style that resonated with you?
- [03:58]
C
Actually, Edward has a different style and much more elegant, elaborate. Mine is unusual in the sense as I write exactly the way I speak, and it's best described as, hopefully, high quality bullshit. And Edward is a professional writer, so it's a very different style and puts a real challenge for Edward to try and manage that difference.
- [04:25]
B
So where I see it is, as Jeremy says, he was never going to quite get around to writing the book himself. My view was that Jeremy, as you're aware, had this big volume of investment letters, of oeuvre of investment letters going back to 2000, some of which were really, to my mind, and anyone who read about the investment in the last 25 years thought they were first rate. So my view was anyhow that there was a lot of material there that deserved to be preserved in book form. Leaving aside, you know, the ups and downs, Jeremy's career, with regard to my own role, I have thought about it. I thought for a while perhaps I was like one of these surrogate mothers, which is a sort of unpleasant metaphor. But then actually I.
- [05:14]
C
That mother, I think.
- [05:17]
B
Then actually, Jeremy, the way I see it now is that I'm more of a tailor, is that Jeremy provides both the model, the figure, and he also actually provided me with the material, the cloth. And my job really was to cut the cloth, to fit the model and to have. Because Jeremy and my voices are so different, it's actually have as little of my voice in there as possible. And when Jeremy was going through the drafts, whenever he saw my voice creep in, out would come his red pen and it would go, which is how I think it should be.
- [05:54]
C
On the other hand, because Edward was the boss. He determined in the end what would go in and what would go out. And so he molded the presentation so there are, like most people, there are several aspects to everybody. We all have different currents running inside. And Edward decided which of those would be presented to the public, which would be useful for gmo, my firm, and which would be kind of expensive sidetracks for which I'm infamous. And the financial world doesn't really need to hear too much about climate change and toxicity and the deficiencies of capitalism. Ironically, the things for which I became well known, they want to hear about the stock market. And we know this to be a case because we've had some amazing controlled experiments where we did half an hour on the stock market bubble and half an hour on investing in climate change or something like that. And the title would be as Good as it Could Get, Investing in Climate Change. And then the results would come in on YouTube and it would be a record 180,000 views for the stock market and not even 10% for the climate change version.
- [07:27]
B
Yeah. And that book, in a way, actually it's true, I decided what went in and actually Jeremy decided what went out. And how I composed the book was to give really 80% weighting to the investment financial side and the 20% to Jeremy's green activities, ideas and philanthropy. That's the balance. And I think it's fair enough. It sort of roughly matches the decades that Jeremy, the proportion of his career he spent in those different and has.
- [07:59]
C
The virtue of being at least as much as the financial people can stand. And I get that now more than I did at the time.
- [08:08]
A
So before we get into the book where I'm going to put you on the hot seat, Jeremy, I'm going to put you on the hot seat for a second here, Edward, and ask you what was it that made you say yes to this project and how did you go about thinking about Jeremy's life, what was interesting and how to mold and balance what, what it was that maybe he thought was important with what you thought was both more objectively interesting that audiences as an author and a historian would find interesting and would sell books.
- [08:38]
B
First of all, I'd finished that big book, the Price of Time that took me six years to do and my batteries were a bit low. So I didn't really want to embark on another six year project immediately. When one of Jeremy's, you know, one of our former colleagues, Peg McGetrick, wrote me, who's director of GMO, said, you know, they were thinking about this project and would I be prepared to do it? As I said earlier, I thought there's enough of Jeremy's material from his letters and so on that worth preserving. Also, Jeremy offered me a job and I worked several years. Jeremy. So obviously I know, you know, I sort of know the ins and outs of how Germany thinks as well as anyone. And so I thought I was probably in a good position to do it. And frankly, because Jeremy offered me work, I was able to save more and go back to a life of writing. So I felt I owed Jeremy one anyhow. So those are sort of various reasons for doing it. I certainly would not do this project. I would not dream of doing it for anyone else for sure.
- [09:46]
C
You're a financial world historian and my 60 years goes back to the Neanderthals. I mean, there was no financial investment management industry back in the day when I started. There was very little talent, very few ideas, not even an options model. I mean, there were the failed younger sons of rich families who would hold hands at lunch for Morgan Guaranty Trust and buy their client an occasional few shares of Coca Cola or Exxon. That was it. That was the investment business.
- [10:27]
A
Let's get into the book. The title of the book is the Making of a Perma Bear. I'm curious about the thought process that went to this title because I've never really thought of you as a Perma Bear. And I'm curious, what was the thinking behind the titling of this book? Was it meant to be somewhat tongue in cheek?
- [10:43]
C
I voted for having inverted commerce around permabank to make it clear, but I was outvoted by Edward Dimitri.
- [10:52]
B
I don't know. In the first chapter and talking about Jeremy's thought processes, he mentions the way he's always approached thinking of the investment world, which is to say, what is going on here? And I think that was the way when I was talking to Jeremy and putting together the book, I thought that that was really the mark of the way Jeremy approached things is that if you go into the world, investment world, or any world for that matter, and say to yourself, it doesn't matter what the conventional view is, what do I think with fresh eyes is going on here? Is, I think a very interesting way of looking at the world. Anyhow, so that was my preferred title, but the publisher was adamant against it, that title. And so some or other it came around to the Making of a Perma Bear, which as you say, is tongue in cheek, because as it's made pretty clear Jeremy's reputation of a Perma Bear is really formed during those periods when the markets are at extremely high valuation levels compared to their history. So yes, I think perma barrier is time cheap.
- [12:06]
C
But let me just add one of the things I think we agree on is that the world is ludicrously optimistic. Homo sapiens is ludicrously optimistic, hates bad news, very good at putting the head in the sand. This is revealed just as much in climate change toxicity and all the bad things. We just don't want to deal with them. We want to have happy thoughts. And if you're a contrarian and if you're trying to see reality, that means that the mainstream is overwhelmingly, in terms of time, on the wrong side of fair value. They're all going to be believing that the market is going up all the time and any value based contrarian is going to think they're overdoing it the great majority of the time. And if you end as we do at the end of the longest bull market run in history, or nearly so, then you are going to look like a perma bear. If you merely make the point that reasonable value is what it is, that is going to seem awfully pessimistic. And in the late stages of a bull market, people develop a something close to a hatred for bears. Anything that interferes with the rising market and their rapidly growing portfolio's value, they loathe.
- [13:32]
A
I suppose your experience of maybe falling out of favor is a topping signal in and of itself. We'll have a chance to dig more into your investment philosophy throughout the course of this conversation, Jeremy, but I'd like to ask you a question first about the book's dedication. The book was dedicated to your grandfather, Joseph Cook, who you write had an outsized impact on your life. He was in some real sense a father figure to you. Can you tell me a little bit more about him and why he was so important in your life?
- [13:59]
C
Yes, he was as important as most father figures are. And he was the man in the family. He was kind, thoughtful. We would sit on his knee and he would declaim poetry in the way that old grandfathers born in the 19th century tended to do Tennyson and how heroic the British Empire was and other things. And brought up a Quaker as he was. He was thoroughly brainwashed by Quaker principles and never said a bad thing about anybody, never did a bad thing as far as we can construe history. And it was easy to admire him and I did.
- [14:42]
A
Well, in the book you say that even to this day, when you go to a restaurant which I find somewhat hard to believe, but I take it at face value that you still look for what is a bargain on the menu before you decide what to order. Is that really true?
- [14:54]
C
It's not only is it true, but I am shocked that you find it hard to believe. There are quite a few of us who do that, by the way, and it doesn't matter whether we're in the money or out of the money. It is a reflex and it has more to do with waste. I don't approve of spending large sums of money on superficial things like eating and drinking.
- [15:17]
A
All right, so you eventually you made your way to the United States and you began to apply your skills to the world of finance. And in the book you highlight a few of the important formative experiences you had as an investor, notably investments in American Raceways and Market Monitor. What made you choose these examples to highlight and how did these experiences inform your evolution as a value investor?
- [15:41]
C
Because I had this rather brief 18 month window into how much more optimistic other people can be. I was deep into momentum and wishful thinking and kind of to the moon. To the moon. And we didn't really pretend that they had serious value. We bought them because we thought they'd go up a lot in a hurry, we would make money. And for a long time they did. For a while they did and they went up rapidly. They double in three months, that kind of thing, as the equivalent does today. And then they blew up. So we paid quite a price in terms of lifestyle, postponed living as cheaply as we could to save money to go back to England or Germany, and then I blew it all in about six months. And that was a wonderful lesson, that you can be cynical, you can be doing it because you're confident you're going to get out quicker than the enemy, and then you can still be surprised by the sheer speed with which they implode when they go. That was the thing. It wasn't that they went. I knew in a way they'd go sooner or later, but I didn't think they'd just blow up and in a few weeks go to nothing.
- [17:00]
A
Edward, when you were interviewing Jeremy for this book and you were exploring this particular period of his life, and I imagine just hours and hours of interviews that you'd done, what made you want to focus on these formative experiences? And more generally speaking, how important is the role of personal experience, especially the experience of loss in the course of financial speculation to one's development as an.
- [17:24]
B
Investor, in your view, Jeremy's descriptions of losing Money in Market Monitor and American Raceways. These are the go go stocks of the 1960s. And that it's not a very well known period of speculative euphoria compared to say, the dot com boom of the late 90s or even the meme stock boom of 2020, 21. But yeah, it's a nice episode. I think Jeremy somewhere says that in investment there are some things that you really have to learn through personal experience. Someone can tell you to keep away from super specs or they might tell you to keep away from stock tips from your friends or whatever. But it does actually help to. Yeah, it helps to lose money. I often think, as you know, Demetra, if you work for an investment firm, when you're pitching to clients, they always put the years of experience underneath. I used to think this was a bit ridiculous. Some might have a lot of experience and many years, but not learn much from it. But I think the point is that Jeremy got very severely burned very early on and at that moment seem to have turned more or less overnight into what we'd call a conventional value investor. So I think probably, as I say, it's good to get those lessons out of the way quite quickly in your career.
- [18:56]
A
Well, reflections on mean reversion, I think reflections on mean reversion and also career risk, and that comes up quite a bit in the book. But at what point, Jeremy, in your career did you come to the firm conclusion that everything in markets is mean reverting? And what led to this realization?
- [19:11]
C
I guess I always thought it was intuitively obvious that history counted and anything that had happened pretty consistently for 100 years or so was probably happening for some reason. And the other thing was mean reversion has this idea of replacement cost, that something is substantially worth what it costs to replace. And brand image plays a role in changing that a bit. But how much would it cost to replace Coca Cola's brand? It's hard to calculate, maybe impossible. But that idea that the brand replacement, which took scores and scores of years as a measure of value, is a pretty good one. And so you look at assets which include intangibles, and you think that's the replacement cost. And you would imagine that prices optimistically would move upwards from there and pessimistically downwards from there, but they would be sucked back to the real value or the cost of replacing it.
- [20:23]
A
So you say in the book that price to book is junk, I think is the term you use to describe it as a heuristic for determining value. Why is that not a great way to determine whether a company is a bargain or not.
- [20:34]
C
What I say is that it's the market's vote on what are the least valuable assets at book value per dollar. And that's exactly what it is. So you have to beware that when you're paying 20 cents on book, that the real replacement value of that asset has probably really shrunk. And it has. That's all that that thought tries to get at.
- [21:01]
B
Can I introduce something about Jeremy's early work on mean reversion? Because if you remember in the book what Jeremy does in the early 1970s, and you have to bear in mind this is a period when there's no historical electronic data on performance of. Of share of different factors or strategies, as you might call them. And what Jeremy does, as we describe in the book, is he works out by hand, taking the data from 1926 to 1970, and works out by hand the performance of an equally weighted index relative to a market weighted index to show and what he discovers from that, and this is an empirical discovery rather than a sort of theoretical idea on the nature of mean reversion. What he discovers from that is the ebb and flow of small cap relative to the broader market. And I think it's this, what they used to call ebb and flow, what we would call cyclical movements. And that is this ebb and flow that you see generally applying to small cap later, to value later, to international stocks later to emerging markets, and then to the broader markets themselves, to the broader stock markets to see the ebb and flow around valuations. Now, in a way, we all take that pretty much for granted now, but in the era when there was no data readily accessible, everything had to be calculated by hand. I think that the discovery of the ebb and flow of and the mean reverting nature of the market is actually pretty significant.
- [22:52]
C
We looked at the rate of regression to the mean of return on equity. We took samples, big companies, little companies, high return, low return. And we worked out, did they in fact regress, and if so, how much? And the answer came back, you bet they regress faster than we imagined. 15% of the gap between normal or average and their return would disappear in a single year. So if you were 4% and the average was 12, 15% of that, 8 points would go in a single year. And if you're only earning four points, that's enough to give you a real kicker on earnings and make it very difficult to work out whether the 4% returning companies would have stronger earnings growth than the 20% earnings companies. And in fact, it was very difficult and they weren't nearly as different as you thought, because the guys earning a preposterous 40% return would be so busy regressing that they would regress by 5 or 6 percentage points in a single year, and that would knock 15 or 20% off their potential earnings. On the other hand, of course, they would be retaining such a large amount of that that would be offset. So the war of attrition between a tendency for poor returning companies to regress upwards and for large returning companies to have an enormous amount to reinvest each year was a very closely run battle. Some years the high return guys would win, and some years the low return people regressing would win and value would win. 2 out of 3 years for 100 years ending in 2000, for the 20th century, value beat the socks off growth stocks, Low return companies beat the socks off high return companies. Why? Because the rate of regression was underestimated and it persistently and reliably regressed. And as we know, that pattern became much less clear after about 2000.
- [24:58]
A
So in natural systems, ecological, geological, climate, et cetera, there are certain generally recognized dynamics or attractors, like gravity, the ratio of predators to prey, the carrying capacity of the land that we can point to as clear drivers of mean reversion. What have you identified or what would you point to as the equivalent primary drivers in financial markets?
- [25:24]
C
Not so much in financial markets, by the way. When I arrived, it was what does it in a typical capitalist enterprise, in an industrial company making chemicals, making machines? What drives it is very, very simple. If you make abnormally high profits, you suck in competition. If you make 4% return, you frighten competition far away. And after a while, having had no new capital flow into that industry, there's a capital shortage and the returns begin to move upwards, hence regression. So it's a very, very straightforward enterprise. And if regression doesn't work, I would say cast some doubt on how healthy capitalism is. If obscenely high returns do not drown you in competition, there is something wrong. And since about 2000 that something wrong has been increasingly obvious to everybody. And that is a growing element of monopoly and protection for these high return companies.
- [26:27]
A
So I feel like since the 08 crisis, there have been a few periods where one would have expected prices to mean revert were it not for policymakers extending the window. The most recent obvious example is the COVID 19 pandemic. If you think that valuations are high, but policymakers can intervene to keep them higher for longer, how does One, balance the empirical time series of mean regression with the objective evidence that governments have the power and incentive to keep the game going. Every time that it looks like it's.
- [26:58]
C
Going to stop, I think it falls clearly into the category of this time is different. If you had very little political interference, commercial interference, into the laws of the land and so ON in the 20th century, you might expect capitalism to work more effectively and quicker. And as you get into the 21st century, I think, for lack of a better description, the rich and powerful have more influence. Rich companies start to outpoint poorer companies, big companies outpoint smaller companies, and the gap in all of these is concentrated. So the concentration by industry has gone up in every industry. In some it's quite small, in some it's monstrous, and the average is quite a lot. So the monopoly factor, which was always around, has steadily grown. And the monopoly factor tallies with what? At GMO we view quality. Quality is high, stable return with no debt. And it's a high return because it's monopoly. It's stable because they're price fixing and they have no debt because they don't need any debt, they're making so much money. So our definition of quality is basically a workable definition. And monopoly and high quality companies in America have won. The AAA stock has not underperformed by a point like the AAA bond has. Everyone knows the AAA bond, you pay a price for security, but they don't pay a price. You don't pay a price for a AAA stock for the last hundred years, the last 20 years, the last year, high quality companies have slightly outperformed the S and P. They should not do that. They should have underperformed by a point a year according to financial logic, according to capitalist logic, but in fact they've outperformed over the last hundred years by about a half a point a year. This is of course the biggest and longest loophole in the efficient market hypothesis, which when it started out back in the 70s, didn't breathe a word about quality and what an exception to that general rule it was that you'd be able to buy stable higher return companies and make extra money. That is not efficient by any definition of efficiency. They missed it. And at the time we knew it and we modeled it in simple ways even back in the 70s.
- [29:40]
A
Edward, your most recent book, as you mentioned earlier, is the Price of Time. How do interest rates and the price of time factor into this issue of mean reversion and the long extended sort of Indian summer of this bull run? Well.
- [29:56]
B
Obviously in the price of time being a history of interest and as some people say, a polemic against the ultra low interest rates and the post crisis period. One of the things I did in that book was to reexamine the history of the great spective manias. Not from the perspective of behavioral madness of crowds type stuff, but just looking at the monetary environments of the great manias, starting with the tulip mania in Holland in the 1630s. And what one finds is that I think in every case there's a conference between easy money and the boom. It's not necessarily the only factor at play, but it's a consistent factor. And obviously I'm not the first person to make that point. It tends to get pushed aside, I think. And I was just trying to bring it back to the fore and I think we had in the last five years pretty good demonstration of that thesis because you had the world falling to pieces as the pandemic rolled out and as these economies closed down, locked down, stock market took a tremendous hit. And as we all know, the Fed and the other central banks came out and expanded their balance sheets by $8 trillion and the governments went out and spent $8 trillion of deficits thereabouts and the market came back in the most speculative manner. We were talking earlier about Jeremy's go go stocks of the 60s, but nothing compared to the flaky nonsense that was trading sky high prices in 2020, 21, then 22, interest rates start to rise the first time since the financial crisis and you get a decent bear market and a big crash in the bond market and by this time the meme stocks are down 90% or so. And then you get a sudden recovery, recovery of stock market linked to AI, which I'm sure we'll talk about later. But if you then look at the monetary background to even this resurgence of stock market over the last three years, it would seem there was a lot of liquidity left over from the pandemic period and that even interest rates themselves, while being high obviously compared to zero, they remain loose in real terms after inflation and historic relative to say nominal GDP growth. I think even this period now we often hear about we live in a period of high interest rates. But in fact actually historically the monetary background even of the current market is relatively loose. It's looser than for instance it was at the end of the dot com bubble.
- [33:05]
C
I share completely Edward's view that the regime of low interest rates is a bad idea. And going back 20 years, I've been fond of telling this story that Greenspan and His two acolytes. I give Powell a pass on this one, incidentally, but Bernanke and Yellen and Greenspan were all pretty much a package. And they made it pretty clear that there was an asymmetric statement going on here. That is, if you run into trouble, I will do my best to bail you out, and if you run into good times, I'll leave you on your own. And that's an asymmetric undertaking from the Fed that would guarantee a slow but steady increase in speculation. But they conducted an experiment. If you start with Greenspan, you look back at the debt to gdp, all manners of debt, corporate included, and you see that it's rising very slowly with the introduction of new financial instruments. It's creeping across the page, and then under late Greenspan, it makes a 45 degree turn and starts to charge up across the page and it triples. So you triple the debt to GDP ratio in 40 years in the biggest country in the world in terms of economy and substantially the biggest stock market, et cetera, et cetera. And you ask a question, what was the virtue of that increased debt? And what is the virtue of low interest rates? The virtue of low interest rates, economically, is it allows you to borrow money. So it's the debt that makes the difference. The assumption here is that if you have more debt in the system, you will have more rapid growth. So, wonderful experiment, 45 years, biggest economy, triple the debt, not tickling it around the edges. And what happens to gdp? It kinks almost at the same time and starts to grow substantially less fast than it did prior to that. So in the lower debt era, it was growing at a substantial 3.5% a year. And post that, it starts at two and a half, it goes to two. It's now about one and three quarters. On its way to one and a half, on its way to one and a quarter. In my opinion, there are some pretty cast iron reasons for that. Productivity is slowing and entries to the workforce are slowing. Population growth is slowing down.
- [35:42]
A
Does that point to financial repression and more government intervention into the economy? If we reach this type of asymptotic, diminishing returns on the debt, that's clearly.
- [35:53]
C
A possibility, is that the intrinsic growth rate goes down. The authorities refuse to accept it. And in one podcast I said it's, Bernanke thinks he's got a racehorse, but he's got a donkey. And he's going to keep whipping that donkey until it either turns into a racehorse or drops dead. And that was the problem. And you know, Bernanke was not as smart as he's meant to be. He studied 1929 and drew all the wrong conclusions. And there he was in the housing bubble. Some of the best data statistics in economic history. The US housing market had been incredibly stable, famously stable throughout history. It had never bubbled. And he said the US housing market had never declined. He was absolutely right. It had never declined because it had never gone up. And then under the remorseless pressure of Greenspan and Bernanke, every market, for the first time in American history, every regional real estate market goes up. The historical tradition was you bubble in Florida while you bust in California or Chicago and now you're all going up. And so just looking at the data, you have a three sigma over less than one and 100 years in a random series, would that occur? It's a real serious outlier and out peak on the page. Three years steadily going up. And he said right at the top, the U.S. real estate market merely reflects a strong U.S. economy. I mean, where were his advisors? How can a serious economist miss a three Sigma market? And where it sucked in, it sucked in 2 to 3% of extra people who had never had a history of buying houses into buying a house and they were all squeezed out. If you look at the housing bubble, it's three years up, peaking.06 and then three years down and then some overcorrection for a few years. It was a magnificently well behaved regression to the mean bubble in housing prices. Explain to me how Bernanke could miss it. Explain to me how Bernanke's reputation seemed to stay more or less intact. I don't get it.
- [38:12]
B
Demetri, Can I just add a couple of comments about the US housing bubble because I think it's pretty important for understanding bubbles. First of all, go back to the discussion we were having earlier about the role of interest rates. The Greenspan Fed cut interest rates, the Fed funds rate down to 1% in 2002, kept them low. Huge amount of money going into securitized mortgage debt. Creation of this investment grade paper satisfying a yield for hunger that throws more money into the housing market. So you see a clear relationship between interest rates, credit growth and asset price inflation in real estate. But the other thing this goes back to mean reversion is that you also see a massive pickup in building, in real estate development and new home building in the States. And it's this new home building that creates this overhang that then brings about the collapse, the very sharp collapse in US house prices. Whereas we have these other cases of housing Markets in different countries like the UK and Australia both have very inflated house prices in similar levels of valuation as US, but no supply response. And because of the lack of a supply response, the house prices actually, even after the financial crisis, remain very elevated. And then you look at these other housing markets like Spain and Ireland, again, huge supply response, huge amount of overbuilding and collapse. So this in all markets, the degree of investment. As you know, I've written a couple of books about the so called capital cycle, but the capital cycle itself plays to my mind a very key role in mean reversion. And if one's to ask, why has the US been so. Why has the US stock market been so elevated for such a long period of time? It's partly, I think, because after the financial crisis, investment remained in the States relatively low. You had a large number or growing number of monopolies and a large number of, of tech monopolies that turned into the Mag 7. And up until recently, we get onto it later. Up until recently, investment remained relatively constrained. The way I look at it, and this is what I used to try and persuade my colleagues in asset allocation at GMO is let's not just look at valuation alone, let's look at valuation and the underlying investment in both the companies and sectors and the markets as a whole to try and see where we think mean reversion is going to be happening and when it's not.
- [41:15]
C
Edward, I don't think it affects whether there will eventually be mean reversion. If you make it much more expensive to own a mortgage, the house price will come down. What the overbuilding does is it determines the timing. If you overbuild, that combination will guarantee it's fast. If you don't overbuild, then you have to wait maybe even decades for the effect of the high priced mortgages to grind it down. You might expect now, 20 years later, that the prices in the UK would be drifting down, which they are.
- [41:49]
B
And actually we have a really nice real time experiment we do in the United States this time because as I was saying earlier, we've had interest rates normalized to some extent and mortgage costs have gone up and yet the housing market hasn't cracked. And I think one of the reasons hasn't cracked, if you bother to read anything about U.S. housing statistics, is that the amount of new building over the last decade or so has been remarkably low. So there is actually very little section.
- [42:22]
C
But the other reason, and I think the most powerful reason, applies to one of the people in our team at the Grantham foundation who lives in Washington. And he has a mortgage of 2.7. And if he wants to move, he has a mortgage of 6.9 in Boston. And that is so brutal, he can't move. And so the house doesn't go on the market. And that's what happens all over America. It froze the market. And the proof of that pudding is that the turnover rate of houses has dropped way down off the historical chart.
- [42:56]
A
I have one more question before I move us to the subscriber only portion of this conversation. And it has to do with, well, it kind of builds off of this question that I asked earlier about financial repression. So what I learned as a younger man was that when you thought assets were overvalued, you did your best to raise cash and look for a buying opportunity. And you had to contend with the uncertainty of how long it would take and the FOMO that arose and also the self doubt that crept in the longer it took. But if you're also worried about the debasement of your currency holdings, if you're worried about the prospects of inflation reigniting or some other existential risk to your capital, how do you position yourself to be a buyer when the time comes, but also to protect yourself from those kinds of risks to your capital that exists today?
- [43:45]
B
I was going to say instead of keeping your money in cash, you could keep it in your dry powder in cash, you could keep it in gold. The trouble is that gold has itself formed rather bubble like proclivities over the last couple of years. Yeah, I think your point, this question of financial repression, of keeping, of the authorities, keeping interest rates below the rate of inflation in order to encourage people not to keep too much cash on reserve. This is not new. I mean, anyone who's been investing since the turn of the century has been faced with constant periods of negative real interest rates and often during those periods of negative real interest rates, very strong stock market performance. It's made it very expensive to sit on cash. And if you look, I think you look at the moment, you see Americans have record low levels of cash holdings. So I have a certain amount of sympathy for that. I think that if one's going to go for a period, a prolonged period of financial repression and occasionally periods of relatively high inflation, it will wipe out your cash reserves. And so I think probably the answer to that is to try and invest it.
- [45:08]
C
Let me just kind of wrap up my thoughts on the stock market. And that is by a decent margin, this is the highest price market there has ever been. And that is using the techniques that have the best predictive record over the last hundred years from 1925, where the data starts to be pretty good. So we have a super overpriced market in the us. The point is you don't have to own cash or the US equity market. And what we've been recommending for quite a long time is our quarrel is with the US market. The rest of the world is nowhere near as expensive as it's ever been. And the gap between the value of the US market and the rest of the world a year ago was as wide as it has ever been. And for the record, yes, last year the US market did a whole lot better than one might have guessed. But it didn't do nearly as well. Our GMO, the International Value Fund was up 45 for the year and it's opened this year with a bang too. Emerging markets was up 35 and you know what? It's up in January, nearly 10% because January is for the flakies. And emerging for good or bad gets classified as a small cap volatile stock. But the non US equity market doubled the US last year in round numbers and has more than doubled the S and P in January. So that point tends to get lost in the bearishness around the S and P. You don't have to own cash, you don't have to own gold, which did brilliantly. The safer bet was to own diversified non US equities, and it still is.
- [46:56]
B
The other thing, Dimitri, is if the main debt burden is in the advanced economies, the US and certain European countries outside of China, the emerging market debt markets are less going through such a severe debt cycle at the moment. My former colleague, Jeremy's colleague Tina Van der Steel runs the local currency emerging Debt fund at gmo. I actually think the local currency emerging debt is a potential nice balance to the equities in your portfolio. And those equities, as Jeremy says, being mostly outside the us with the odd.
- [47:36]
C
Exception, half the cash is parked in cash reserves. Liquidity reserves are parked in emerging debt in my family accounts. And a It was up 22% last year. But the most shocking thing is that over 32 years since the inception, it's up 12% a year.
- [47:55]
A
So I'm going to move us to the second hour of this conversation. Guys, I'd love to dig into this a bit more as well as some of the allusions to political risk that I was making and existential risks questions about demography climate. This is something that preoccupies a substantial portion of the book. So I'm looking forward to talking about that as well. For anyone who is new to the program, Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second part of today's conversation with Jeremy and Edward, head over to HiddenForces IO, subscribe and join one of our three content tiers. All subscribers gain access to our Premium feed, which you can use to listen to the rest of today's conversation on your mobile device using your favorite podcast app. Just like you're listening to this episode right now. Guys, stick around. We're going to move the rest of our conversation onto the Premium feed. If you want to listen in on the rest of today's conversation, head over to HiddenForces IO, subscribe and join our Premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces IO, you can follow me on Twitter cofinas, and you can email me at infoiddenforcesio. As always, thanks for listening. We'll see you next time.