Is it Possible Bernanke has Seen the Light?

Marc Faber calls him a dangerous inflationist. Nassim Taleb likens him to an arsonist who now has the task of putting out the fire he started. Despite his mild mannered, soft spoken nature, could Ben Bernanke and his seemingly religious beliefs about financial markets be long term threats to the stability of the US? In general, I worry that his willingness to monetize the US debt has put us on a path to uncomfortable levels of inflation. But, from his comments this morning (as covered by the Associated Press and printed in the NY Times) to members of the American Economic Association, there may be some hope that the events of the past few years have taught him something about the dangers of misguided monetary policy.

First, when I read the headline in the Times I almost fell out of my chair. The article is titled "Bernanke Calls for Regulation to Fight Future Bubbles." Say what??!! You mean that the guy who basically said he did not believe in bubbles was actually advocating some kind of policy response to prevent bubbles? If true, this would be tantamount to Alan Greenspan's recent admission that the financial meltdown had proved to him that the entire framework from which he had viewed financial markets during his career was wrong. That statement is still shocking to me in terms of its magnitude. Kind of like a Minsky Moment, I would deem this a Greenspan Moment. For me, that would be like Warren Buffett, Ben Graham and Seth Klarman being exposed as Bernie Madoff-like frauds. If value investing turned out to be nothing more than an elaborate, multi-generational Ponzi scheme I'm not sure what I would do. I can assure you that getting out of bed the next morning would not be particularly easy.

Could Bernanke really have come to a commensurately game changing realization? I was skeptical but I had to find out. Fortunately, as investors we are blessed by the Fed’s never ending desire to be transparent and the speeches by the Fed governors are posted on its website. Bernanke’s speech starts off in a promising way (for those of us who want to Fed to understand the potential disastrous effects of its decisions):

“Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.”

Promising, but not particularly introspective. This paragraph seems to imply that the Fed sees itself as an evaluator of the failures of other agencies and the legislative body as opposed to a willing participant in all of the bubble era madness. This type of dissociation from the systemic problems that have emerged recently is clearly troubling and indicates an unwillingness to seriously examine what role the Fed played in creating the housing bubble and allowing financial institutions it was supposed to be regulating to become levered to the hilt.

“Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices.”

At least he understands the criticisms that have been thrown so vigorously at the Fed from a wide range of politicians, economists, bloggers and market professionals. Personally, I agree with Bernanke to some extent that interest rate policy may not be the best tool for popping or preventing asset bubbles. To me that would be like trying to tee off with a baseball bat; good luck trying to precisely drive the ball. Unfortunately for the Fed, this does not absolve the members of responsibility for allowing the housing bubble to inflate so dramatically as the Fed was one of the primary institutions in charge of curbing predatory lending and excessive balance sheet growth. Also, with the benefit of hindsight I think it is very hard to argue that the excessively low interest rates in the early part of the decade were appropriate given the macroeconomic circumstances. I am not an economist but it seems logical that historically low interest rates, especially those stemming from the zero interest rate policy in place now, should only be used in very dramatic circumstances.

Not to downplay the significance of the impact of the September 11^th attacks or the bursting of the tech bubble but I am unsure that a response to those events that included leaving interest rates under 2% from December 2001 to December 2004 was justified. Bernanke exhausts a lot of energy attempting to defend the monetary policy of this period by citing low inflation and a jobless recovery as contributing factors as well as illustrating how the Taylor Rule that indicated that rates were too low was not the perfect metric. However, my focus is not to admonish the Fed leaders for past mistakes, especially since Bernanke did not become Chairman until 2005. My concern is simple: until the Fed is willing to recognize that there are severe risks to leaving interest rates at depressed levels for an extended period it is likely to continue to play a major part in what I see as a particularly negative perpetual boom and bust prone US economic model.

“To set the stage for the discussion, Slide 5 shows the annual increase in nominal house prices from 1978 to the present.¹¹ After some years of slow growth, U.S. house prices began to rise more rapidly in the late 1990s. Prices grew at a 7 to 8 percent annual rate in 1998 and 1999, and in the 9 to 11 percent range from 2000 to 2003. Thus, the beginning of the run-up in housing prices predates the period of highly accommodative monetary policy. Shiller (2007) dates the beginning of the boom in 1998. On the other hand, the most rapid price gains were in 2004 and 2005, when the annual rate of house price appreciation was between 15 and 17 percent. Thus, the timing of the housing bubble does not rule out some contribution from monetary policy.”

Hmmm, in 2004 and 2005 housing prices were growing at more than twice the rate seen in 1998 and 1999 and at least one and a half times the rates seen in 2000-2003? Shouldn’t that have been a sign that the housing market was getting a bit frothy? Maybe, according to Bernanke, but in his mind the magnitude of increase had nothing to do with monetary policy. Instead he blames it on poor underwriting standards and exotic mortgage products:

“With respect to the magnitude of house-price increases: Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.¹² This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory…”

“The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed. This description suggests that regulatory and supervisory policies, rather than monetary policies, would have been more effective means of addressing the run-up in house prices.”

Also, Bernanke argues that since housing prices were increasing across the globe during this period, if low rates were the culprit we would expect to see a similar impact across countries. According to Bernanke the data does not support a correlation between monetary policy and housing appreciation but does support a relationship between a global savings glut (and the associated capital inflows from emerging markets) and housing booms:

“As Slide 9 shows [click through to see all of Bernanke’s slides], the relationship between the stance of monetary policy and house price appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and greater house price appreciation than the United States. The overall relationship between house prices and monetary policy, shown by the solid line, has the expected slope (tighter policy is associated with somewhat slower house price appreciation). However, the relationship is statistically insignificant and economically weak; moreover, monetary policy differences explain only about 5 percent of the variability in house price appreciation across countries.

What does explain the variability in house price appreciation across countries? In previous remarks I have pointed out that capital inflows from emerging markets to industrial countries can help to explain asset price appreciation and low long-term real interest rates in the countries receiving the funds--the so-called global savings glut hypothesis (Bernanke, 2005, 2007)… The downward slope of the relationship is as expected--countries in which current accounts worsened and capital inflows rose (shown in the left half of the figure [see Slide 10]) had greater house price appreciation over this period.¹⁸ However, in contrast to the previous slide, the relationship is highly significant, both statistically and economically, and about 31 percent of the variability in house price appreciation across countries is explained.¹⁹”

Based on all of this fancy statistical data, Bernanke draws the following conclusions:

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak. Because monetary policy works with a lag, policymakers' response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period--though certainly accommodative--does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives. House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases…

The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country's overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms…

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach. Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era. Maintaining flexibility and an open mind will be essential for successful policymaking as we feel our way forward.

And there folks, highlighted above, seems to me to be a bombshell. Just the hint that monetary policy could be used in the future to address the risks associated with asset bubbles appears to indicate a very positive evolution in the thinking of the Fed Chairman. Over the last year I have read the majority of his speeches and correct me if I am wrong, but I do not recall him ever been this forthcoming and open to adjusting Fed strategy when it comes to asset bubbles. Was this Bernanke’s Greenspan moment? Does this mean the Fed is going to be much more aggressive in raising interest rates this time around? Are those worried about rampant inflation or even hyperinflation going to be proven wrong as a result of a new Volcker-like philosophy coming from Bernanke? I am skeptical based on his historical bias towards inflation, his extreme fears of deflation, his desire to prevent another deflationary Depression, his staunch defense of past Fed looseness, and his beliefs about the impact of monetary policy on the housing bubble. But, those final words provide me with a modicum of hope that I sure did not have when I woke up this morning. Maybe 2010 is going to be a better year than I have been anticipating.

Do Stocks Provide a Sufficient Hedge Against Inflation?

Smart investors and markets commentators ranging from Warren Buffett to Marc Faber have recently argued that purchasing stocks is one of the best ways for people to protect their wealth from the ravages of inflation. The common refrain is that certain quality businesses with pricing power and durable competitive advantages are able to pass along input cost increases to customers and therefore earnings are able to keep pace with the inflation rate.

This sounds like a logical argument and it makes sense that stocks would retain their values better than bonds and/or currencies. Clearly, domestic currencies are losers in an inflationary environment as investors holding cash are able to purchase less and less with each dollar they hold. Also, as inflation rates increase, yields on bonds will inevitably rise as central banks hike rates in order to fight inflation or investors demand higher yields in order be compensated for a drop in purchasing power. In this case, the prices of existing bonds would drop as yields rose. Some would argue that TIPS offer a degree of protection from inflation due to the return being indexed to CPI inflation. My concern is that TIPS present a glaring conflict of interest between investors and the issuer, the US government. The government has the incentive to understate CPI inflation in order to keep its debt servicing costs down. Maybe I read too much content on Zero Hedge and have become too susceptible to believing in conspiracy theories, but I would not feel secure owning TIPS knowing that BLS will do anything and everything it can to limit the impact of interest payments on the deficit.

If bonds and currencies aren’t going to defend against the inflation demon, then what about gold? Followers of the gold markets know that gold spiked from about $100 an ounce in August 1976 to over $850 an ounce in January 1980. According to this chart, that high in 1980 would be worth $2189 in today’s dollars. So, even though gold topped $1220 an ounce this year it is still far below its inflation-adjusted high over the past 30 years. But, what were the inflation rates during that period? This BLS data indicates that rate of inflation was 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981. This compares to 3.8% in 2008 and a likely much lower rate in 2009 as there have been a number of negative inflation months in 2009 (based year on year comparisons). Despite recent mild inflation rates gold has gone from $500 an ounce in January 2006 to just short of $1100 today even though annual inflation never even broke 5.6% during that period. To me this past performance indicates that gold could increase significantly, even from the current levels, if inflation were to approach the 1979-1981 levels.

The problem with gold, of course, is that its intrinsic value is just about impossible to measure. Since it produces no income investors can’t use any kind of discounted cash flow method to value the yellow metal. That doesn’t imply that owning gold does not protect an individual against excessive money printing and proliferation of fiat money. It just means that it is very difficult to assess when gold is under- or over-valued. Thus, my justification for owning gold in my portfolio traditionally has been similar to that of Bruce Greenwald of First Eagle Funds:

“The hedge that we’ve had is gold, which has protected us. The attractive thing about gold is that it has no industrial uses. It’s strictly something that, when everything goes wrong, it’s going to do really well. I think people have learned to appreciate that… Mutual funds really can’t use this strategy, but good value funds are thinking about hedges, which are really forms of insurance…In our mutual fund, gold is the primary hedge.”

The idea of gold as a form of insurance resonates with me, especially given my concerns about the monetary and fiscal policy decisions that have been made over the last few years. So, I don’t look at gold as an inflation hedge necessarily. If the late 70’s and early 80’s experience is predictive at all, gold surely will do well if inflation picks up. The problem is that I have become a little uncomfortable owning gold after its huge run-up just in the last 15 months. Unlike a company that I can value using price to earnings and price to free cash flow metrics in order to determine whether there are better investment alternatives, gold offers no such measurement opportunity. Even as a form of insurance, at a certain price the cost of the insurance could outweigh the potential benefits. With out of the money puts and credit default swaps investors can estimate the worth of these hedges under a number of different market conditions. Investors in gold are unfortunately at the mercy of traders, speculators, Indian jewelry demand, commercial bank short interests and even a US Federal Reserve that has no interest in exorbitant gold prices.

So, with all of the issues with gold, I guess that leaves ownership stakes in businesses as the best inflation hedge, right? Bruce Greenwald thinks so:

“The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.”

I never had any reason to doubt that rationale until I picked up the December 2009 edition of Value Investor Insight. In this issue Colin Moran and Geoff Gentile of Abdiel Capital discuss their study of the impact of inflation on stocks:

“The U.S.’s last stretch of high inflation was between 1973 and 1981. In the early 1970s many equity investors, as they do now, imagined generally rising prices would make earnings grow faster, sending stock prices higher and giving investors a good real rate of return.

It didn’t work out that way. Inflation turned out to be a kind of neutron bomb that left revenues and profits standing while decimating the free cash flow available to owners. Even if a company’s GAAP earnings kept pace with the general level of prices, higher working capital needs and increased prices for capital spending meant that free cash flows failed to keep up with the price level.

Overall, inflation and taxes together stripped public-company owners of more than 100% of their reported profits from 1973 to 1981. We measured that by tracking the book value per share of companies in the Fortune 500, which compounded at 10% per year over that period, adjusting for share repurchases and including the after-tax value of dividends paid out. Someone who bought a business in 1973 and sold it in 1981, in both cases for book value, would have actually lost ground. After capital-gains taxes, the investment would have doubled, but over the same period the overall price level more than doubled.

And most owners would probably have done worse. Having for years failed to produce real returns, businesses traded in 1981 for less relative to book value than they did in 1973. As a result, stock prices grew more slowly than book values. The S&P 500 added only 3% annually during this stretch – again including the after-tax value of dividends – but since inflation compounded at 9% per year, stocks’ real value declined 40%.”

Wow. A 40% decline is pretty ugly and seems to fly in the face of the often quoted benefit of stock ownership as espoused by Buffett and Greenwald. If stocks didn’t protect purchasing power, then what about bonds?

“Treasury bills, reinvested every three months from 1973 to 1981, compounded at 8% per year. Long-term government bonds bought in 1973 and held to maturity delivered less. Assuming total state and federal taxes consumed a third of the interest income, Treasury bills ended up delivering a 5% after-tax yield. Cumulatively, these “risk-free” Treasury bills lost 30% of their real value. It's worth emphasizing that tax-paying investors need to compound way above the rate of inflation just to maintain purchasing power. If prices are stable, any positive return gives you a positive real after-tax return. But if inflation is 10%, a investor paying taxes needs 15-20% returns to keep wealth from losing its purchasing power.”

Yikes. A 30% loss in real value is better than the 40% loss that stocks experienced, but neither did the job of protecting purchasing power. Did anything do well over this period?

Gold and oil compounded in the low-20% range in the period. Residential real estate also rose slightly faster than the general price level; and the equity of homeowners with mortgage rates set in the early part of the decade obviously rose faster than the assets themselves. Not all stocks are losers in an inflationary environment. The 25 highest-ROE companies in the Fortune 500 compounded book value at 15% annually from 1973 to 1981. Warren Buffett compounded Berkshire Hathaway's book value at around 20%. In general, businesses that could support a fair amount of leverage, had decent pricing power and had limited capital needs did well. We expect the same to hold true if inflation rekindles in the future.

It comes as no surprise to me that an investment strategy focused on high quality, high return companies served as a reasonable form of protection. It comes as even less of a surprise that value investing as practiced by The Oracle of Omaha was the best of all the strategies.

What should investors conclude from all of this data? Well, at first blush it looks as though gold and oil could potentially be viable inflation hedges, given that the current price does not already reflect future inflation expectations. The problem with both is that there is almost no way to know what is embedded in the current price. Inflation concerns? Supply-demand imbalances? Geo-political fears? Irrational speculation? Accordingly, I think the data corroborates what Buffett and Greenwald have been stressing recently. But that does not mean that blindly owning a stock index is going to be a saving grace. Instead, investors need to focus on buying shares of companies with conservative management teams that are prudent capital allocators and that have sustainable competitive advantages. It is my belief that such stocks purchased below their intrinsic values and with a sufficient margin of safety will always offer investors the best opportunity to compound their wealth irrespective of the inflation rate.

(Picture courtesy of http://www.creditwritedowns.com/)