"For the first time, the US stock market has become the instrument of...

James Grant on trouble spots in the US market, gold and what the Fed is doing wrong

Published 9 years ago on Apr 12, 2015 13 minutes Read
Ashesh Shah

Market historian Jim Grant has been in India for only three days and when we meet him on the last day of his trip, he jocularly proclaims, “I am an authority on the country, ask me anything,” When we ask him for his most interesting story during his first India visit, he deadpans, “My happiest story is not being killed as a pedestrian. What I did not know about India is that there is a contest among drivers to see who can maim the most pedestrians.” Grant may clown about the apparent absence of pedestrian courtesy or about how ‘well-informed’ he is about India, but his fortnightly newsletter, Grant’s Interest Rate Observer, dour sounding as it maybe, is regular reading for most seasoned market participants in the US. His bi-annual Grant’s Conference is also a must-attend as most speakers are accomplished heavy-hitters. Grant is also a long-standing critic of the Federal Reserve’s monetary policy and his innate distrust for central bankers was a natural starting point for this interview.

You have long held the view that post the 2008 credit crisis, the market should have been allowed to correct itself and prices would have eventually found their level. Yet the Federal Reserve’s pump priming has pushed the S&P 500 to a new high. What is the market missing?

Nothing. Years ago, I would have said, yes, I will give you a list of what the market is missing. But I have realised that as a slightly arrogant state of mind. Markets can also be hugely efficient and can astonish you with how they figure things out.

There is no logical disconnect between successive interventionist bailouts and the S&P making a new high. For the first time, the American stock market has become the instrument of national economic policy. The Federal Reserve holds a view that it is the duty of the central bank to stimulate and enhance the economic life of a nation through the manipulation of interest rates and the creation of credit. They believe that through the artful conjuring of credit and dexterous manipulation of interest rates, they can increase employment. They think they have this in their power. I say they don’t.  To me, this is the transformation of central banking into central planning. I think the Federal Reserve and other central banks pursing these policies are creating more problems than they are solving.

Most institutional investors apparently don’t agree. Are you calling the all-time S&P 500 high, phony?

Well established financial theory holds that the value of a common stock is future cash flows discounted by a suitable rate of interest. If the rate at which one discounts future cash flows is an artificially suppressed rate, it means the market is imputing a false value to the securities. 

Hence, the market is at a level at which it would not have been, but for these muscular central bank interventions. If it were this easy to create prosperity through the conjuring of dollar bills, why didn’t we discover this a long time ago? Why has mankind waited for thousands of years to discover that all you need to be rich is to get the government to print money? It’s a shame we didn’t think of it before. 

For now, they have gotten away with it. People with jobs are content. Even more content are financiers who borrow and lend for a living. Wall Street has been cosseted and subsidised with 0% funding cost and it is great if you are in the business of speculation or leveraged investment. 

Would you say this is unprecedented?

The Federal Reserve is 100-years old and it suppressed and manipulated interest rates as soon as America entered the Great War and it did the same thing in WWII. So, that is not new. What is new, however, is the Federal’s Reserve overt and explicit enlisting of the stock market in its campaign to make the country richer by moving asset prices higher. I keep on thinking that asset prices ought to go up because the country is getting richer. They ought not to be bid up to make the country richer. 

The Federal Reserve is enthralled to many academic theories, one of which goes by the fancy phrase: portfolio balanced channel. It says that if you get some asset prices moving, good things happen. To me the idea that wealth creates income does not make sense. The sustainable way is freedom of action and lower taxes and to let nature take its own course. 

Would anything change under the new Federal Reserve Chair Janet Yellen? 

She wants to be just like Ben Bernanke. She believes that the Federal Reserve ought to be doing what it is doing, in the interest of the nation’s prosperity. She is not a Grant’s reader, sadly. 

Larry Summers was a front runner to replace Bernanke? Did he pull out because he felt that the current situation would have been too much to handle?

He didn’t pull out, he was pulled out. He wanted the job desperately. He graciously withdrew because the 2/3rd Senate votes to confirm weren’t there. A lot of people didn’t like Larry because he was impolitic in certain things he said. Larry did not pull out except optically and diplomatically.  

How will the endgame play out, according to you?

The future is a very difficult subject. In fact, we are not so sure about what happened in the past and the present is rather murky too. Regarding the future, I haven’t got a clue, but I do have some theories. The one likely consequence of the Federal Reserve’s talking up the stock market will be the creation of another financial mess. 

Since January, 2014, we have turned an unfriendly face to the market. We think the stock market is at a point where it is easier to find shorts than longs. There is more risk than reward as there are many candidates in the world for financial disruption. China being at the top of the list, it is an accident waiting to happen. Its credit system has been overlending and overborrowing at the wrong rate of interest on the wrong collateral and for the wrong purposes. Loans have been made against inflated collateral or against raw material specifically imported into the country to serve as collateral, for example: iron ore or copper. 

Continuing with my speculation on the consequences of what I imagine will happen, either the US market gets into trouble and/or Chinese credit implodes. And when the next crisis happens and the junk bond market falls apart, what will the central banks do? They will intervene again and this time the Fed will have to do more as the market is already unsatisfied with $65 billion in new credit creation every month. They call it tapering. Almost everybody in India asked me, ‘What do you think about the tapering?’ 

Is there any particular trouble spot in the US market that you are worried about?

One sector that we think is ripe for re-pricing and a little sanity is US biotech. With an market cap of $700 billion, it is the epicenter of a new kind of detachment of finance from business reality (see: High on drugs). The valuation is higher than ever before, the suspension of disbelief is as great or greater than in 1999 in tech stocks. It is not big in market cap as technology was in March 2000 but it is big enough to signal that something is wrong. 

Even, corporate debt is aggressively priced and the spread between junk bonds and the 10-year is at a record low. Investors are going into leveraged sectors in search for income. Mortgage real investment trusts hold mortgage backed securities which have five or six times more leverage than pure equity and that leveraged yield is appealing to investors.

High on drugs

Total marketcap of Nasdaq Biotechnology index companies

China has been talked about as a spoilsport for a long time, but it has not happened. The closest was when one of their shadow banking investment trusts was on the verge of default in late January…

Yes, I know, weren’t they supposed to blow up, like, four years ago? You can’t time these things. The Chinese are not to going to say, ‘Having read the recent issue of Grant’s Interest Rate Observer, we think that the time has come to let the market determine its price and we will withdraw our credit stimulus.’

They are going to throw everything at it but the laws of arithmetic are still going to come into play. Do you recall what the about-to-default investment product was called: Credit Equals Gold No.1? Clearly, it does not. China just had its first bond default earlier this month. Just give them time to blow-up. It will happen. 

You keep on asking ‘when’. I feel as if I was looking at myself with respect to Japan in 1986 and 1987 and 1988 and I used to ask myself ‘when’. It happened on 31st December 1989 after everyone else had given up.

 But Jim, at that time there was no coordinated central bank intervention. Now everybody is pouring monetary gasoline to maintain status quo and keep away deflation.

In this age of technology, when the cost of producing things is falling, the price of buying things ought to fall as well. The price of everything, from the incandescent bulb to combustible engines fell consistently in the final quarter of the 19th century because of great advances in science and technology. Nothing then was as disruptive as the Suez Canal. It cut off weeks from the time needed to get from the West to the East and bankrupted merchants who had invested in warehouses in London. The Economist rued the day they dug the damn canal and wished that it hadn’t happened but it did. 

Never richer

Price-to-book value of the Nasdaq Biotechnology index

In consequence of all these wonders, prices fell. Today we have the worldwide web, 3-D printing and new advances in everything you can name. Why aren’t prices falling? Well, because we have an academic literature that says its deflation. Why don’t they call it progress? For the Fed, price stability means 2% inflation. 

 Does your bullishness on gold stem from the fact that the Fed is trying to push CPI up and when its desperation finally pays off, the resulting inflation will be too hard to tame? Hedge fund billionaire John Paulson said last year that he will not be adding to his positions as it was not clear when inflation would take off.

The price of gold is a reciprocal of the words and deeds of central bankers who manipulate paper. The less faith you have in central bankers, the more you will be drawn to gold. Paulson had a pure monetarist’s view that central bank credit creation equals price inflation, more or less in a linear fashion in a reasonable amount of time. That didn’t happen because the velocity of turnover had slowed so much. He hasn’t abandoned gold. There was a sharp correction last year and he traded around his position having taken a capital loss. But I own this stuff and will hold it. It is not a perfect hedge against anything but it is insurance. You cannot buy insurance after the fire starts as the premiums get prohibitive. I bought some more insurance recently at $1,200.

How do you explain the recent bounce in gold from around $1,200 to about $1,375?

The bounce was a normal reaction against the severe and violent downdraft of last year. Investors sold it for tax purposes and there was a kind of late January effect. Things which do badly in December start snapping back in January. There were a lot of short positions created as well. Then, there was a request by the Bundesbank to the Federal Reserve of New York to repatriate its gold back.

The gilt hedge

Grant believes gold is an insurance against an impending financial implosion

One hypothesis is that the gold has been hypothecated in the market and the Federal Reserve has accepted paper claims in lieu of the metal itself and that is the genesis of some of these theories about governments suppressing the price of gold. In general, there is no conspiracy because on Wall Street, people can’t hold secrets.

 Do you have an eventual price target in mind for gold?

Higher is my number. Famously, it pays no dividend and it earns nothing. So, you cannot value it as an equity asset. For me, it is insurance against the logical outcome of ideas held by our monetary masters. I think the ideas are unsound and that is why I want insurance against the consequences of those ideas.

To me, gold is a special speculative asset that the world will go to once the current system has failed. Right now, the system in place is delightful for both the political and financial constituents. Politicians love the system in place because they have a ready made means of financing fiscal shortfalls. Most financiers on Wall Street love it because they are in the business of manipulating paper and for them zero percent funding costs couldn’t be better. 

During the next crisis, what is it that will stop investors from rushing into the US 10-year than gold?

Investors continue to view the United States as a great safe haven and they view the dollar as the world’s currency. As a patriot who happens to be bearish sometimes, I have said that those ideas need to be re-examined. The 10-year is neither good nor bad intrinsically. It all depends on the price. It seems to me that 2.75% is not a good yield right now given the determination of the central bank to create more inflation and its record of intervening at the drop of a stock with more credit creation. 

It could be that all this ends up in deflation. To me deflation is not falling prices because of progress; it is a credit event. Financial institutions going bust, companies unable to finance themselves, inventories being liquidated, labour being sacked with a resulting fall in prices and wages – that to me is deflation. In that case, it just might be the US 10-year at 50 basis points is in fact not a bad investment. We have to see at that time. I have lived long enough to see investors fly away from Treasuries in times of distress. As of now, they think it is great.

What economic indicators are you watching now that will tell you that we are a tipping point?

There isn’t one except price action. It will be significant if as and when the biotech sector and the US stock market fall out of bed. It will be significant if there are serial defaults in China. 

How about the co-relation between the USD and gold?

There are no perfect and predictable co-relations. When co-relations are predictable, arbitrageurs game it and the co-relation doesn’t work anymore because of their anticipatory action. Things work until they stop working. It is always an adventure in finance. Nothing is dead certain. In 2008, gold had a bad year. Paradoxically it was the event that people were holding gold for. If somebody told me that the odds were 80% against the rise in price of gold, I would still hold it because human beings do unaccountable things.

How are you managing your personal portfolio in this age of overabundant liquidity?

I outsource it. I am fortunate enough to invest with a fund called Arbiter Partners. I have been singing the praises of its general partner named Paul Isaac. Paul’s record over 10-years is the second-best of all hedge funds in America, it has compounded 25%.  

Finally, how does the Grant’s Interest Rate Observer work? Do you write all 12 pages of it?

When we started out, yes. But now I am only a glorified rewriter. I have three analysts; one of them is my son Charley. I hired him because of his intelligence, good looks and surname in that order. The analysts submit memos and analysis to me and I craft those into stories. Every two weeks is a little miracle, I walk out of office every other Tuesday night 7 pm with a sigh of relief.