Grant's conference notes—Pt 1

This year’s Grant’s conference in New York featured 10 investing gurus and four billionaires. At least one more hung out in the crowd.

You can understand why. This was easily the most valuable conference I’ve attended, which is why I’m bringing you this on-the-ground (but written in the air) report that summarises the most valuable lessons.

Jim Grant is many things but a famed optimist isn’t one of them. It’s unsurprising therefore that the majority of speakers selected for the event were downbeat. Call it selection bias at work if you like. But when investors like David Einhorn, Paul Singer and Stan Druckenmiller are deeply wary, one should take note. So let’s look at their arguments in a little more detail.

David Einhorn on the jelly donut policy

The highly-regarded founder of Greenlight Capital spoke of a ‘jelly donut policy’, a monetary example of the law of diminishing marginal returns. The first jelly donut is sweet and delicious, a pick-me-up. The second makes for an unhealthy meal but the fourth causes you to bend double and rush to the toilet.

Under Bernanke, the Federal Reserve is trying to force feed the market its 30^th donut and then is wondering why things are sluggish. Indeed, Federal Reserve chairman Ben Bernanke was the event’s unofficial punching bag, copping a few swings from every presenter.

In a Doddsville podcast last month, our team provided a well-reasoned but out-of-character argument in favour of further American monetary stimulus. Einhorn presented the opposite:

‘When he (Ben Bernanke) sets rates low, he doesn’t get to choose which things go up in price. He claims he can’t control the oil price, but he’s probably pushing it up. And nothing slows the economy faster than rising oil prices’.

As evidence, Einhorn noted that in the first half of 2011, when the Fed failed to announce a third quantitative easing (QE3), oil prices fell. Then Operation Twist was announced and oil rose again. Einhorn believes that ending jelly donut policy will do more than any government intervention to reduce income inequality in America because rising energy and food costs hurt the poor more than anybody else.

The Fed wants everyone to get out of cash and buy stocks, Einhorn claims, but the Fed is the problem. He can find plenty of cheap stocks, some very cheap indeed. But nobody is diving in because of a pervasive fear that something terrible is about to happen. The source of that fear is the Fed, with its zero rates and price manipulation policy. If it stopped trying so hard to prop up the market, he believes that ‘tail risk’ will be reduced and the market might rise of its own accord.

Einhorn then went even further. Bernanke’s economic theories have been disproved—he pointed to the recent strong negative correlation between stocks and US bonds—and believes the Fed should increase rates from zero to 2-3%. The way to encourage investors to buy cheap and unloved stocks, he argues, is to show them they can also lose money in ‘riskless’ assets like bonds. It would also encourage a sense of urgency that the stock bargains might not last long.

So how does Einhorn position his own portfolio to account for this state of affairs?

His exposure to gold is a ‘jelly donut defence’, although if the Fed started acting sensibly he’d probably sell. He cited Apple as his favourite buy idea. Trading below a market multiple (adjusted for cash), Einhorn believes that iTunes, multiple integrated devices and other advantages give it a moat that previously dominant hardware providers lacked.

As for Europe, he suggests it’s a long way from solving its problems. And currently high US company profit margins might not fully ‘revert to the mean’ due to a ‘lack of antitrust action’.

Hugh Hendry and the tranquillity that rocked the world

The Glaswegian founder of Eclectica Asset Management offered a most entertaining presentation. To give you a flavour of the man, here’s an absurd and hilarious interview with him and a ‘greatest hits’ compilation.

Hendry is an existentialist, claiming that ‘life is truly, truly absurd’. Citing as evidence Eurogroup chief Jean-Claude Juncker admitting that sometimes he has to lie for the greater good, and a world where Treasury Bonds traded at 14% under an inflation watchdog like Paul Volcker and 2% under the ‘bearded one’ (Bernanke), he may well be on to something.

‘Just about everyone in the world is embracing real assets as an inflation hedge. I don’t necessarily disagree with that conclusion. But any such period of hyperinflation first needs a period of hyperdeflation.’

Hendry contrasted Japan today with America in the Great Depression; ‘In the 1930s, America restructured debt. It took steps which made the country stronger. This isn’t happening in Japan. That’s why value investing worked for Ben Graham [in America], and hasn’t so far in Japan.’

He went on to suggest that insurance against the default of Japanese stocks has recently been cheap. ‘Nippon Paper has US$10bn of debt versus a market capitalisation of $2bn. It only survived because it can borrow at 1%.’ The past decade has taught investors that Japanese companies can’t go bankrupt and that, he claims, is the wrong lesson. Chinese growth (through negative real interest rates and a dollar-linked currency) saved many Japanese companies from bankruptcy.

‘I think the yen is toilet paper. But further exogenous shocks might send it the other way first.’ Looking at the global picture and paraphrasing Hendry:

We are single-digit years away from a truly epic bottom in equities (like 1982 or even 1932). We need China to respect the laws of economics and tank. It’ll happen. They’ve had a bigger housing bubble than the US. We will be confronted with one more hyper-deflation event’ (with China and Europe likely causes).

Paul Singer and the shape of the next financial crisis

The founder of Elliot Management Corp was careful to state he was talking about the ‘shape’ rather than the ‘timing’ of the next financial crisis but once it comes, ‘it will be faster and more shocking than the last one.’ (James Grant pointed out that Singer presented at a Grant’s conference in 2007 and ‘showed everyone how to make a billion shorting mortgages’).

According to Singer, the first element in the next crisis is that financial institutions remain opaque and over-leveraged. Because of opacity, analysis is useless and the markets will run harder on rumour, setting off a domino effect. Europe is also part of the next crisis. Greece, Portugal and Spain need growth and to be restructured. Instead, they’ve got austerity.

Entitlements are another part of the problem. Long-term entitlement and health care benefits in the US, Europe and Japan are, according to Singer, unaffordable ‘regardless of growth rates’.

The guarantors of the last crisis (governments) should be the subject of great concern today, Singer argues. America as an idea, a collection of beliefs about how best to do things, has never really been questioned. Now, with the ‘trust me while I print money’ approach, it may well be.

If investors say ‘enough’, Singer wouldn’t be surprised to see bond yields rise ‘a few hundred basis points in a few days’. That would be a monumental shift. He cautioned investors first to not lose money and to expect surprises. ‘Always assume the world is being governed poorly or extremely poorly’, he implores. Hard to argue with that.

Singer prefers ‘uncorrelated’ assets that are only affected by the liquidity impact of a crisis, explaining why Elliot has generally focused on distressed investing. Lehman Brothers debt is the group’s largest position and Delphi was one of the most rewarding restructures it’s been involved in, despite not getting in until late (the northern spring of 2009).

Elliot holds a large gold position but through call options and spreads. It wants a very large position in the case of an ‘asymmetric, parabolic up move’, but with downside protection. Translating, that means Singer believes gold is a good investment, but far from a certainty.

Stanley Druckenmiller

Before lunch, James Grant interviewed famous investor Stan Druckenmiller, once the right hand man to George Soros but also independently successful with Duquesne Capital. 

Let’s start with his most important point, at least from an Australian perspective. Druckenmiller is a top down investor and much of his success has come from taking positions on currencies. Indeed, he played a substantial role in Soros’s famous 1992 punt against the British pound that reportedly made a billion dollars profit:

‘I am short all the commodity currencies, particularly Australia’.

Confirmation bias is an insidious influence but, after arriving at our own conclusions regarding the Australian dollar, having one of the world’s most famous currency traders agree is unavoidably comforting.

Druckenmiller believes that perhaps in the next two to four years there will be another crisis or major test. Bear markets don’t really get resolved until you attack the problem, and thus far we haven’t. As evidence, 1970-72 showed a ‘hell of a rally’ from misguided policy, including protectionism. But it took Fed chairman Volcker to deal directly with inflation before the bear market really ended around 1982.

The 1970s crisis was caused by inflation; today’s by debt. The response hasn’t been ‘Volcker-like’ and ‘we never made the adjustments that will end this thing started in the 1990s’. Consumers have begun deleveraging but there’s been no overall deleveraging because public balance sheets have been loaded up in an attempt to solve the problem.

Regarding his short term trading, Druckenmiller noted that in Japan quantitative easing (QE) pushed stocks up and everything appeared to get better. When QE ended, it came apart in six months. The same happened in the US with QE1 in 2009 and QE2 from August 2010 to mid-2011.

In October 2011, Operation Twist was announced. ‘We’re up 30% since’. Twist is scheduled to end in June. Druckenmiller believes that the only way to trade at the moment is to ‘trade the monetary stimulus. I think we’ll have a problem starting in a month or two’ [because of the scheduled end of Twist].

But he is bullish on the US dollar, in part because shale gas at US$2 (per thousand cubic feet) provides a long-term competitive advantage compared with US$14 in Asia. ‘The Fed chairman will always find a way to be dovish, he says. ‘He’ll view high oil prices as a tax (deflationary). If the oil price is high while GDP shrinks, you’ll see QE3.’

Druckenmiller explained how he views gold as a currency: ‘When monetary stimulus is on, I’m long gold. When stimulus is off, I’m less long. You have to be exposed to gold, confidence could disappear. The way to do it is through options, because if it goes it’ll go hard. It could go to US$2,400-2,500 an ounce’.

In the next few weeks, we’ll summarise the thoughts of six other superinvestors, including famed short seller Jim Chanos and fifty-year market veteran Joe Rosenberg.