Portfolio manager’s Letter February 2004
I have written a couple of times recently about the amount of political distortions that dominate the subject of America’s trade deficit. One final comment in the general form of a summation, and I promise I will not bore you with the subject any further. What have I learned about the trade deficit since I started writing on the subject?
First of all, I have arrived at the conclusion that 98% of the noise about the subject is politics. Now when I hear some talk about the twin deficits or American profligacy, I look to see where the author is coming from. It is mostly either some politician trying to get elected to something; or some businessman or labor leader whose ox has been gored by foreign competition, and is looking to the government to bail his ass out.
There is no question that the dollar was, and probably still is overvalued. But the reason for this has nothing to do with American consumers desire to own an infinite number of flat panel TV screens. The dollar is over valued not because of our desire to buy, but because of rest of the world’s desire to sell to us.
The trade deficit exists because of the power of the American consumer, and while it is likely that currency markets will remain volatile, and may even perhaps get violently more so in the near term, the underlying factors that are the cause of this overvaluation of the dollar are not likely to change in our lifetime.
What do I have to support these conclusions? One thing is the current market for US treasury securities. Last month there were two big auctions of treasury securities. The demand at the auctions was so strong that interest rates went down about 25 basis points. So who is buying all these bonds, and why? The rumor is that 40% to 50% of the bonds sold where purchased by the Bank of Japan. Why does the Japanese Central Bank need all this low-yield American paper?
Japan has been going through a twelve-year economic contraction and has recently experienced the beginnings of a recovery. The American economy is getting stronger and we are starting to buy a lot of stuff from Japan. US dollars are flowing into Japan and as the dollars flow in, a lot of them end up in Japan’s central bank, the BOJ. The BOJ can sell those dollars or the can hold them. The problem is, if the bank dumps the dollars, it drives the price of the dollar down relative to yen.
The last thing that Japan needs right now is a weak dollar. A weak dollar makes Japanese goods more expensive for the American consumer. With the American economy the only large economy showing much life right now, if the Americans stop buying, the Japanese economy goes back in the toilet and existing Japanese politicians will be looking for a new line of work.
But it is not just the Japanese, In the last three months of 2003, foreign central bank holdings of US government securities grew by 37.4%. Two weeks ago the Russian Central Bank announced that it was buying dollars. The dollar has declined 12% in the last year relative to the Ruble and Vladimir Putin thinks it important that Americans should not have to face a cost increase for their Stolichnaya Vodka (thanks Vladimir).
The US has a trade deficit because the dollar has been overvalued for a long time. It has been over valued because foreign central banks like it that way. When they get dollars, and to the extent that they can, they hold on to them (use them to buy US treasury securities). The foreign central banks like it that way because the local politicians like it that way.
Everyone wants to sell to the American market. If you have a product and you aspire to world-class status for that product, you have to be able to sell successfully in our market place. Without a share of the American market it is difficult to generate enough revenue to achieve the economies of scale that you need to compete in the international market place.
Assuming that some or all of this is true, what does it mean, and what are the consequences? Well I would not expect that the long-term trend will change much. It is likely that the dollar will stay weak or even decline further, but because foreign companies are still going to want to sell their products to our market.
The dollar is not likely to decline to the point that our current account deficit will disappear. The dollar is likely to remain overvalued because the rest of the world would prefer that it does. The short term may be more interesting. The imbalances have become so glaring that it has attracted a lot of currency speculators, and history tells us that once the speculators start to smell blood, central banks can get crushed.
In the unlikely event that the dollar were to suddenly fall to the level where its trade deficit would be eliminated, the pain would be much greater over-seas than it would be here. In the US prices would increase for imported goods, but this negative would be off-set for us by increased profitability for companies that export and a rapid increase in employment in the manufacturing sector.
On the other hand, countries that sell goods to us have benefited from the strong dollar because it makes their products cheaper, and a sharp drop in the dollar, if maintained for a long period, would see rising unemployment in industries that rely heavily on the American market. Profitability of companies that sell to us would fall and if the decline was sustained, it could lead to debt defaults and bankruptcies.
As for the stock market, I personally will stay away from large financial institutions like J.P. Morgan Chase, BOA, or Citibank because of the off-chance that currency traders might set off a small nuclear accident in the derivatives market. But I was going to stay away from those stocks anyway (derivatives-related to real estate mortgages are probably a much bigger threat). On the positive side, it is probably time to start looking for companies that will benefit from rising commodity prices and lessoned foreign competition.
Last year, despite his view that the market was overvalued Jeremy Grantham correctly predicted that the market would rally. He is looking for another up year this year, but after that he sees a return of the bear. If you do not want to read the whole thing here are the highlights:
“As a new devotee of the presidential cycle, I think we can count on a high probability of a relatively stable stock market year. The value of the market, which on a 1-year basis never matters as much as sensible investors would like, simply does not matter at all in year three, but in year four, it has an almost normal effect and obviously at 25 times normal profit margins, this is a very overpriced market. However, the stimulus program was profound and the economy has responded and this momentum is an obvious positive.”
In other words presidential politics trump value when it comes to guessing at the direction of the market in the third and fourth year of our presidential election cycle.
“On average, value stocks (or low growth) also have their best year in year four; perhaps just making up for year three’s overdoing it with growth stocks. My conclusion is that the economy, profits, and the market are likely to do quite well or better in the first half, and less well in the second half, as the stimulus runs out and the over pricing of the market is felt.”
2005 and 2006 are likely to be the time when the problems caused by too much pre-election financial ease and the resultant asset bubbles will likely turn the stock market into a black hole. The outlook for 2004 is not bad, but the market is very overpriced and all predictors look bad for next year and the year after.
“The purist’s investment position is clear: the market is overpriced and investors should duck! The problem with this strategy, as we have all painfully learned over and over again, is that an overpriced market can really run, and this overpriced market has quite a lot going for it in the near term … “I am confident — but far from certain — that the long-term problems already discussed, which will affect every country, lie out beyond the next 6 months and probably this year.”
The thing that bothers me is that I almost completely agree with this view and when the people running big money agree with me, I start to get nervous. In the second part of this article Grantham discusses factors the effect the direction of the market on a short-term (one year) basis and finds three strong predictive indicators:
While this may sound superficial, the article is an interesting read, and Grantham is no slouch. 2003 saw his company GMO increase its assets under management from $23 billion to $54 billion.
An interesting aside to his study is that “Value” analysis is a lot weaker predictor of one year performance than it used to be.
“The decline in predictive power in the last 30 years is disturbing to worshipers of mean reversion.” (Value investors) … “What is going on here? Is value, surprisingly, being used so much that it is losing its power … This raises an important, but not too surprising issue: to win on value, you must be prepared for increasing noise and greater pain and time on average before you win.”
Warren Buffett has been successful for a number of reasons, but for most of his career he has been an outlier doing things differently than the Wall Street herds. In the last ten years he has become much more widely known and his teachings much more popular with investors big and small. What impact this will have on the new and future practitioners of value investing is at this point an open question.