A Real Asset Call Option

US fund manager Jeremy Grantham has published his latest quarterly letter to shareholders. Grantham writes mostly about US markets. But his fund’s strategy is global. And his December letter makes two useful points for Australian investors when it comes to your investment assets.

The first point is that the recovery from the global bubble could take – prepare yourself – 14 years! Grantham shows that each bubble in the stock market not only returns to trend, but breaks below and stays there for years. He writes:

Historians would notice that all major equity bubbles (like those in the U.S. in 1929 and 1965 and in Japan in 1989) broke way below trend line values and stayed there for years….The first of the two great bubbles that broke on their watch did not reach trend at all in 2002, and the second, in 2009 – known by us as the first truly global bubble – took only three months to recover to trend. This pattern is unique.

GMO has looked at the 10 biggest bubbles of the pre-2000 era and has calculated that it typically takes 14 years to recover to the old trend. An important point here is that almost no current investors have experienced this more typical 1970’s-type market setback. When one of these old fashioned but typical declines occurs, professional investors, conditioned by our more recent ephemeral bear markets, will have permanent built-in expectation of an imminent recovery that will not come.

If investors are waiting for a recovery that is just around the corner, but are stuck on a 10-year straightaway, they’ll probably own too many of the wrong stocks. Grantham also produced the pleasant chart below. It shows what the 10-year aftermath of a credit bubble might look like for the S&P 500. The short answer is: a lot like today, minus the 10-year holding period.

S&P 500 1995-2011 and projected overshoot 2011-2021

How is this point useful to Aussie investors? The Aussie market is still tightly correlated to the US market. This, we suspect, is because global asset prices are keyed off of the global supply of credit. If we’re in a credit depression, US stocks will stagnate. Aussie stocks will track that stagnation.

This is pretty handy to know if you’re in a balanced fund that’s depending on capital growth. It means you will probably be pretty disappointed with the next 10 years. It also means you might consider changing your plans and not depending on rising stock prices to pay for your retirement.

The second useful piece of information in Grantham’s letter is just one sentence, although to be fair it’s a pretty long sentence. He writes that, “I like (personally) resources in the ground on a 10-year horizon, but I am nibbling in very slowly because, as per my Quarterly Letter on resources in April 2011, I fear a major short-term decline in commodities based on a combination of less bad weather – which has been bad, but indeed less bad – and economic weakness, especially in China.”

Grantham wrote about the case for commodities at length in April of this year. That April letter makes the same point our own Dr. Alex Cowie has been making for a year now: the fundamental driver behind resource prices is the inability of supply to catch up with demand. Look for Alex’s new research on the subject in a few days.

Aussie investors can take heart from Grantham’s resource point. It means that companies with proven reserves in the ground – or even just a large, undefined resource – may be better long-term investments than existing producers. Why?

Existing producers are vulnerable to falling commodity prices. They are vulnerable to rising capital and labour costs. They’re also vulnerable to lower global economic growth. That’s a long list of vulnerabilities.

If we’re in a Credit Depression in which financial asset prices are going to fall or go sideways in real terms for many years, Grantham is arguing that you’re better off accumulating real assets that are still in the ground. These are like savings bonds, but denominated in metal, ore, or tangible assets.

One way to think of this strategy is like buying a call option on future economic recovery. The option gets cheaper the further asset prices fall. And unlike a real option, there’s no time decay. You just have to make sure the company that owns the rights to the mineral or energy resources is a going concern and can stay that way through a long drought.

Luckily, Alex is on to a few of those. Stay tuned for more. Unluckily, the Australian government has chosen to tread down the path of the European Welfare State. This means more taxes, permanent government deficits, and astoundingly stupid policy proposals. More on the plunder and looting of the Treasurer tomorrow.

Dan Denning,
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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