Saturday, November 10, 2007

Thinking about Chuck Clough and Jim Grant

      I have probably spent way too much time thinking about financial markets and my past/current employment in the financial services sector.  Two common threads have been going through my mind as I go through all the turmoil and uncertainty:  the first is that the political and economic climate (as well as some of the responses to it) are way to similar to the 70's, and the second is how the opinions of two prognosticators, Charles I. Clough (formerly the chief strategist of Merrill Lynch until sacked in 1999 because he was not "bullish" on equities enough) and James Grant (the long time publisher of Grant's Interest Rate Observer).

     As for the first point.   I think I'll leave it to say that history repeats itself, the first time as tragedy and the second time as farce, and will save the rest for another post.

     But back to my thoughts.   During the late 90's, I was working for a brokerage firm that beame Merrill Lynch Canada.   One of the perks of "Mother Merrill" is that they have TONS of reports at your finger tips.  So I downloaded everything and anything of interest.  The two people I gravitated to the most were  quantitative analyst Rich Bernstein and chief investment strategist Charles Clough.

   Clough was canned by Merrill for not being sufficiently bullish in the mid to late 90's during the tech bubble.    He advocated then a 50/40/10 stocks/bonds/cash portfolio when most of the competitors were advocating an 80/10/10.  His reasoning was as follows:

  • There was too much money floating around the economy.  Easy credit and low interest let to a rapid cap-ex spree.  Companies were financing additional capacity with debt.   Companies would continue to produce products as long as they could eat into the fixed costs.  This led to deflationary pressures as prices dropped to keep production at full capacity.
  • Inflation was not an issue because China and other emerging markets were able to absorb all this cap ex and still provide low prices, which the American consumer bought up in record amounts.
  • All this surplus money also found its way from capital assets to financal assets - driving up the prices of stocks beyond their fundamental fair value.
  • The U.S. economy, in his view, was a giant balance sheet with huge amounts of debt and equity being tied to inflated asset values. Clough figured that the day of reckoning would come soon whereby the national balance sheet would need to be de-leveraged to reflect more realistic prices.
 Clough was writing this stuff in 1997-1999.   He correctly forecasted the capex and financial asset bubble that was caused, and would have reasonably seen the bubble migrating from capital assets (e.g. semi-conductor factories, fibre-optic networks) to financial assets (stocks) to real assets (real estate and commodities).   As we have seen, brokerage firms despise pessimism, as it cuts into their lucratvie underwriting business, so Clough was shown the door.

James Grant had similar views.   I have posted previously about a luncheon meeting I was able to attend with the Detroit Financial Analsysts society.  I think his comments require repeating:

  • Jim is/was not impressed with Alan Greenspan, calling him a "glorified civil servant".  Jim believed that Greenspan pumped excess money into the system, ignoring the fact that inflationary pressures would be absorbed by emerging market trading partners like China.  The problem with the U.S. economy is too much money circulating, period.  Not the trade deficit, not the fiscal deficit, but too much money.   Too much money causes bubbles and inflation eventually.  Greenspan was lucky for most of this to happen on his successor's watch.
  • Interest rate cycles are long-term in nature.  They are mult-generational.  Interest rates were on a long-term downtrend from the end of the civil war until early in the 20th century.  This was a period of overall deflation as the U.S. went to a strict gold standard.  The discovery of massive gold deposits in South Africa coupled with the cyanide process of gold extraction changed all this (for additional information - see Milton Friedman's Money Mischief).
  • From the early 20th century until the the beginning of the great depression, interest rates went on a upward trend, culminating with the tightening of the money supply that brought about the great depression.
  • From the great depression until the early 1960's, interest rates went on another downturn, until the great society and the Vietnam war started another inflationary trend that started interest rates to rise - peaking in 1981 when Paul Volker vanquished rampant inflation.
  • The next great bull market in bonds started on that day in 1981 when long bonds were yielding in the high teens until 2004, when yields hit bottom.
Grant's point was that interest rate tends span decades, and what we are experiencing is the end of a long-term decline in rates and the beginning of a long-term increase which should last many years.  We are in a period of transition where assets will start to adjust to this reality.

     Although these comments were made several years ago - they are still appropriate.   I share the opinion that there is too much money in the market and that the supply has to remove this excess.  I also understand that in the short-term, this cannot be done without causing a major recession, as we need liquidity to clean up this mortgage mess.  On the intermediate term, we will start seeing the money supply retrench as these bad loans are wound up.  This will mean eventually higher interest rates, a stronger dollar, and some adjustment to commodity prices.

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