September 23, 2006
I don’t think I’ve ever read a treatise on macro investing — although I suppose George Soros’ The Alchemy of Finance counts. There are plenty of works on stockpicking, and I would point to classics by Peter Lynch, Warren Buffett (or writers who have studied him), Marty Whitman and Joel Greenblatt.
Most people who dabble (or more than dabble) in markets are proto-macro investors of some sort. The investing “herd,” whether amateur or professional, spends an inordinate amount of time checking up on the latest government statistic and theorizing about the course of Fed policy, interest rates, foreign exchange rates and the like. Great stockpickers, like the ones mentioned above, have generally concluded that such concerns are a waste of time. They don’t make any money, in the end, on average.
Guess what? They’re right! But then, stockpicking doesn’t make any money either, on average. That’s why we read the writings of the great stockpickers — the ones who are well above average, and produce well above average results.
Most good stockpickers are average-to-subaverage macro investors, who at least know enough to concentrate on their strengths.
Over time, we will look at a few concepts that may make you a better macro investor. The first principle is:
Things change. The laziest student of economic and market history has surely noticed that things change. Let’s choose a few years from history to show a little of what I mean. We’ll go backwards:
2006: Goldilocks is back! Corporate profit margins are at all time highs, and inflation is apparently under control. There is some concern about the US housing market, but not much. The S&P 500 is very near multi-year highs, having rallied for roughly four years. Long-term bond yields are very low, which is considered an economic positive, although the inversion of the yield curve disturbs many. Equity valuations are high, but not unreasonably high. Commodities have screamed higher, many making historic highs. Emerging market equities have soared from their 2002-2003 lows. Financials account for 40%+ of earnings of publicly-traded US companies.
early 2003: The War in Iraq starts and sentiment is in the toilet after a three-year bear market. Economic conditions are generally recessionary, although the consumer has, uniquely, kept spending throughout. There is some concern of deflation at the Fed. The S&P 500 is off roughly 50% from its 2000 highs, and the Nasdaq has been creamed for over 75%. Valuations for equities are middling, though corporate profits have been weak due to the recession. Commodities prices have been dead since the late 1970s. Emerging markets have generally been forgotten and have been languishing at bargain-basement levels since the EM disasters of 1998.
2000: It’s a New Era in tech-related equities! Non-tech stocks are forgotten and value investors are losing their jobs. Yields are high. The S&P 500 trades for 40x earnings, an unprecedented figure.
1999: The 1998 disaster is forgotten, and everyone gets on the tech train!
1998: Emerging markets disaster causes great apprehension in developed markets as well. Oil hits $10 and commodities are generally in the toilet.
1995: A tepid economic recovery in the US. Emerging markets are on fire.
1990: A recession in the US, with a property bust. The US’s biggest banks nearly go out of business as they reel from bad loans to property developers, LBO operators and EM governments. Japanese banks, however, are on top of the worldä
1986-ish: Boom! Inflation moderates, and interest rates come down under 10%. Equities soar worldwide.
1980-ish: Inflationary collapse worldwide as interest rates soar into double digits in the developed world for the first time since, perhaps, the 17th century. “Equities are dead.” People line up around the block to buy precious metals as they bunker down for hyperinflationary collapse. Oil hits $40, and gold hits $850.
1970-ish: Oil is $2.50, and gold is $35. A recession punctuates a long period of economic development as living standard soar higher since the end of the Second World War. The “Go Go Years” are in force in stocks, a continuation of the long bull market since 1950, although major indices haven’t made much progress since the 1960s. A man walks on the moon. Bond yields are climbing over 6%, however, as investors worry that the government may be heading towards inflation.
1950-ish: Yields are 2.5% and asset values are in the toilet across the board, as many prepare for a resumption of the Great Depression following the WWII boom. The Cold War begins in earnest, this time featuring nuclear weapons. People have seen nothing but warfare and economic hardship (with a brief exception in the 1920s) for 35 years.
1910-ish: Ah, progress! The pace of industrialization is most impressive, profits are ample and equities trade at high valuations of 20x trailing earnings. What could go wrong?
See what I mean? Things change. It’s about the only thing you can count on. Thus, even if you don’t know for certain what is going to happen going forward, you can conclude with a high degree of confidence that tomorrow will be different than today. Oddly enough, the majority of people who put their minds to macro matters tend to conclude that the future will be like the present. Now, it is true that trends take time to play out, and that things may continue in a certain direction for several years. Nevertheless, if you are incapable of envisioning a future that is different from the present, then you will not be able to operate as an effective macro investor. (This is trickier than it sounds, because markets supposedly discount the future. Thus, the present reflects commonly held expectations of the future.)
In a true display of self-delusion, most people do not only assume that the future will be different than the present, but they also assume that the past was similar to the present! Even if they were there at the time, and know that it was not! For example, there are umpteen people in Manhattan who will insist (or did until a few months ago) that “real estate in Manhattan never goes down,” because “they aren’t making any more of it (land)” or whatever other justification comes to mind. Yet, many of these people lived through the property bust of the early 1990s, when apartment prices, according to the New York Times, fell about 50%. In Jersey City, where I lived not too long ago, there is a huge old former factory, sitting in a prime location near the Hudson with Manhattan skyline views and about a three minute walk to the subway. It has about 100 industrial lofts of 1000-2000 square feet — a hundred lofts! — twin freight elevators, the whole deal. Today, the building is occupied by artists, who managed to get the city to “ask” the landlord to leave the building as an artists’ residence rather than converting to luxury loft apartments. The purchase price, in the early 1980s, of the entire building, was $500,000. Or about $5,000 per loft. Think of that.
“But that was then, and this is nowä.” Yeah, sure. Two years ago, you could buy a nice little house in Eastern Germany for $20,000. Maybe you still can. And I saw a company for sale in Uzbekistan, for $700,000, that had 400 employees, a huge factory floor, 150 pieces of heavy machinery, and made $100,000 per year. (It made valves for the oil and gas industry.) A couple years ago, a US investor bought a sports stadium in Fukuoka, Japan, which was built with a titanium roof. (Maybe inspired by Frank Gehry?) The purchase price of the stadium was less than the scrap value of the titanium. And I know a company in China, which is aiming to buy one of the largest drugstore chains in China with 1,000 stores. The price? $7 million, if I recall correctly.
Let’s imagine some scenarios that are different from the present:
Equities have high valuations and lots of attention today, so let’s imagine a time when equities are in the toilet and receive little attention. During the hyperinflation of 1920s Germany, it was possible to buy the stock of the car manufacturer, Mercedes-Benz, at a valuation that gave the entire company a market cap equivalent to the purchase price of a single car! There are some examples not too different from only a few years ago, regarding the equities of companies in post-Crisis Asia or Eastern Europe.
Housing and property values are high now, so let’s imagine a time when they are low. In the early 1990s, when the government was liquidating huge baskets of foreclosed properties from the busted S&Ls, it was possible to buy houses for about 50x monthly rents. Thus, a house that might have rented for $1,500 a month sold for about $75,000. In the Great Depression in the US, a hotel was sold for one ounce of gold.
Bond yields are low now, so let’s imagine a time when they are high. In the early 1980s, 10-year government bond yields were consistently over 10% and reached as high as 18% or so.
Capital is easy to access now, so let’s imagine a time when it is hard to get capital. In 1940, an investor wanted to buy a hotel in Manhattan, but didn’t have enough capital to do it himself. The hotel’s bar was a popular spot in those days. The hotel’s selling price was 3x the annual profits from the bar alone. The investor could find no one to either lend them money or invest alongside.
Commodities have been going up in price, but everyone expects them to go back down. Let’s imagine where they might be ten years from now. In the 1970s, the price of oil and gold went up 20x. What do you think of $500 oil? $8000 gold? $40 copper? $20 gasoline? That’s what it felt like to people at the time when oil hit $40 in 1980, from $2.50 in the 1960s. (I bet a lot of people who were around at the time — and experienced this firsthand — nevertheless think that it would be impossible to see $500 oil or $8000 gold by, say, 2015.)
Geopolitical issues are thought to be irrelevant now, so let’s think of a time when they are of the highest importance. The US imports about 70% of its oil, much of which comes from the Middle East and passes through the Straits of Hormuz, with Iran to the North and Saudi Arabia to the south. These long supply lines are essentially indefensible, and could be cut by Iran, Europe, China, even Cuba, since many tankers pass within cruise missile range of Cuba before docking at ports around Louisiana. Or, to take another example, what if Bush tries to impose martial law in the US, and is faced with not only a rebellion, but a revolution, culminating in the establishment of a new government called the Union of American States? Impossible? Thailand just had a military coup which threw out an elected leader. They are reportedly writing a new constitution. That’s how fast things can change.
These are just thought exercises, not predictions.
Just one notion is all we have space for today. I can tell that we will get a lot out of this theme in coming months.